Question

Forecasting Exchange Rates

Explain two of the methods for forecasting exchange rates and provide examples of how they might work.

Answer 1

1. Purchasing Power Parity: This forecasting approach is referred to the One Price Law, the law is drafted on the basis that identical goods should have identical prices, regardless of the region they are in i.e country in which they are selling. The Cost of buying an iPhone in India and the United States will be the shame after we have accounted for exchange rates and shipping.

For Example

The prices in the united states are forecasted to go up by 6% over the next year and with respect to this, the price in India will be rising by only 4%. Thus, the difference in inflation in these two countries will be 6% - 4% = 2%Based on this assumption, the prices in the united states will rise rapidly in context to the prices in India.

Therefore, the Purchasing Power Parity would forecast that the U.S. dollar will depreciate by about 2% to balance the prices in the united stated and India. So, in case the exchange rate was 0.70 U.S. Dollars per one Indian Rupee, the PPP would forecast an exchange rate of −

(1 + 0.02) × ($0.70 per INR1) = $ 0.714 per INR 1, in this case, we cant get INR 1 in 0.714 Dollars

2. Econometric Models: It is a method that is used to forecast exchange rates involves gathering factors that might affect currency movements and thereby we create a model for relating all the variables to the foreign exchange rate.

For example,

For an Indian company, it is important to know the USD/INR rate of exchange, this can be done by researching a few factors we think would affect the foreign exchange rate between united states and India.

The most influential factors that would affect the Foreign Exchange Rate are as follows

Interest rate differential (INT)

GDP growth rate differences (GDP)

Income growth rate differences (IGR)

By using the econometric model we can say  USD/INR(1 year) = z + a(INT) + b(GDP) + c(IGR)

With the use of the econometric model, the variables mentioned, in the above equation that is INT, GDP, and IGR can be used to determine a forecast. The coefficients used (a, b, and c) will affect the exchange rate and will determine its direction that whether it will go positive or negative.