Exchange Rates Forecasts – Methods and Madness

In the world of finance, the exchange rate, which is also called the “foreign exchange rate, FX, or Forex Rate”, consists of numbers between two currencies, showing the value of one over the other.  Let us say that the Japanese Yen was 91 and the US Dollar 1.  That means that $1 US dollar is equal to 91 Japanese Yen.  Of all markets around the globe, the foreign exchange market is the biggest, with some experts saying currency in the mount of $3.2 trillion exchanges daily.

When talking about exchange rates, this is used for two primary purposes – traveling and investing.  For instance, if you were considering a trip to a foreign country, one of the most important things you should do is understand the current currency exchange rate.  This would help you understand the value of the US dollar for the place where you plan to visit, which is important to control spending.  Obviously, exchange rates are great in some parts of the world and not so great in others.

Regarding investments, if you wanted to buy stock in a foreign country, then to know if you are going to make money on your investment, you have to know the exchange rate.  The thing about exchange rates is that they are not just numbers someone pulls together but rates based on a specific formula.  In fact, financial and economic experts have the knowledge and ability to forecast exchange rates.  Now, when it comes to making an investment, remember that today, there is no one forecasting method is considered better than the other, just different.

Forecasting of exchange rates became the “in thing” when the Bretton Woods System dissolved.  At that time in 1973, floating exchange rates were established.  Unfortunately, this created a more volatile market, which meant that risk management was needed.  Now, systems are in place that can help forecast rates, which have proven to be huge lifesavers.  After all, these forecasted numbers are used by international and multinational corporations in making critical financial decisions.

The two methods of forecasting exchange rates that are used most often include the fundamental approach and the technical approach.  The fundamental approach first considered various factors specific to long-term cycle rise.  For instance, data for a certain country would be looked at based on productivity indices, inflation, unemployment rate, trade balance, and more.  With the fundamental approach, the “real value” of an exchange rate is determined, which makes this a good method for people interested in long-term investments.

The second method for forecasting foreign exchange rates is the technical approach.  In this case, forecasting is based on the investor so changes in rate can be determined and patterns charted.  To use this approach, a number of tools are used such as moving average of trend following trading, Forex dealer flow information for customers, and surveys on positioning, and more.  Typically, the technical approach is used for people more interested in making a short-term investment.

Finally, different models are used as well.  This would include the PPP Model, which stands for Purchasing Power Parity.  In this case, movements of exchange rates would be studied on a per country basis.  Next is the UIP Model or Uncovered Interest Rate Parity.  For this, movement is watched specific to return from investment for two currencies.  Finally, the Random Walk Model is used to forecast exchange rates.  In this last case, movement would be based on rates with future reflection.