# Methods of Currency Rates Forecasting

To predict further dynamics of a currency pair, a huge number of techniques were invented. Nevertheless, the quantity didn't turn into quality, and to receive quite an effective forecast is not the easiest task. We will consider four most widespread methods of the currency pairs rates forecasting.

## The theory of purchasing power parity

The Parity of Purchasing Power (PPP) is one of the most popular methods. It is more often than others is mentioned in books on the economy. The principle of “the law of one price” which claims the cornerstone of the theory of PPS says that the cost of identical goods in the different countries have to be identical.

For example, the price of a chair in Canada shall be the similar to the price of the same chair in the USA, accepting in accounting the exchange rate and excluding transportation and exchange costs. The possibility of speculation in order to buy cheap in one country and to sell expensive in another, should not exist.

According to the theory of PPS, change of the exchange rate shall compensate an inflationary rise in price. For example, in the current year, the prices in the USA shall grow by 4%, in Canada for the similar period – to 2%. Thus, the inflation differential makes: 4% — 2% = 2%.

Respectively, the prices will grow quicker in the USA, than in Canada. According to the theory of PPS, the US dollar shall lose in price about 2% that the price of the same goods in two countries remained approximately identical. For example, if the exchange rate constituted 1 CAD=0,9 USD, according to the theory of PPS the predicted rate is calculated as follows:

## (1 + 0,02) x (0,90 USD for 1 CAD) = 0,918 USD for 1 CAD

That, is, for the observance of PPS the Canadian dollar shall rise in price to 91,8 American cents.

The most widespread example of the use of the principle of PPS is the Big Mac index, which cornerstone the price comparison on it in the different countries and which shows the level of undervaluation and overvaluation of currency value.

## Relative economic strength approach

The technique of this approach is described in the name of it. As a basis are taken different countries' growth rates of the economy which give the chance to predict dynamics of the exchange rate. It is logical to assume that stable economic growth and healthy business climate will attract more foreign investments. Purchase of national currency is necessary for investment that, respectively, leads to increased demand for national currency and its subsequent strengthening.

Such method approaches fits not only when comparing the state of the economy of two countries. With its help, it is possible to size up availability and intensity of investment flows. For example, investors are attracted more by the high-interest rates, allowing receiving the maximum profitability from the investments. Respectively, demand for national currency again grows and it is strengthening.

Low-interest rates can reduce a flow of foreign investments and stimulate internal crediting. Such provision takes place in Japan where interest rates are lowered to record minimum. There is a trading strategy carry trade based on a difference of interest rates.

The difference between Relative economic strength approaches and the PPS theory is that with the help of the first one it is impossible to make the forecast of the size of a currency rate. It adumbrates to the investor only about the prospects of strengthening or weakening of the currency and the strength of momentum. To receive a complete picture, the relative economic strength approach is combined with other forecasting methods.

## Creation of the econometric model

The method of econometric model creation, describing communication of the currency exchange rate with factors which, according to the investor or the trader, influence its movement enjoys wide popularity in currency rates forecasting. Creating the econometric model, as a rule, should be applied sizes from the economic theory, however, in the case of calculations can be used any other variables having an essential impact on the exchange rate.

We will take, for an example, the creation of the forecast for the next year for USD/CAD vapors. As key factors for the dynamics of a couple, we choose a difference (differential) of interest rates of the USA and Canada (INT), a difference in growth rates of GDP (GDP) and a difference between growth rates of personal incomes of the population of the USA and Canada (IGR). The econometric model will have in this case the following appearance:

## USD/CAD (1 year) = z + (INT) + b(GDP) + c(IGR)

The coefficients of a, b and c can be both negative, and positive, and show, how strong influence has the corresponding factor. It should be noted that the method is quite difficult, however, in the presence of the ready model, for receipt of the forecast it is rather simple to add new data.

## Historic series analysis

The method of historic series analysis is exclusively technical and doesn't take into consideration the economic theory. The most popular model in the case of historic series analysis is the autoregressive model of moving average (ARMA). The principle of price models of a currency pair forecasting is based on last dynamics is the cornerstone of a method. The calculation is carried out by the special computer program on the basis of the entered parameters of a temporary row, which is result creation of the individual price model of a specific currency pair.

Undoubtedly, the forecasting of the currency rates is the extremely difficult task. Many investors simply prefer to insure currency risks. Other investors realize all importance of forecasting of the currency rates and aim to understand the factors influencing them. The stated above methods can become a good help for such participants of the market.

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When I was studying economics I've heard of these methods of forecasting. It is difficult to approach for beginners, but the shoes really nice results.

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Such complex approach, it proves once more that trading is occupation for people with economic knowledge and abstract mind structure.