EXCHANGE RATE FORECASTING

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EXCHANGE RATE FORECASTING : 

EXCHANGE RATE FORECASTING

International transactions are usually settled in the near future. Exchange rate forecasts are necessary toevaluate the foreign denominated cash flows involved in international transactions. Thus, exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment. : 

International transactions are usually settled in the near future. Exchange rate forecasts are necessary toevaluate the foreign denominated cash flows involved in international transactions. Thus, exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment.

There are two pure approaches to forecasting foreign exchange rates: (1) The fundamental approach.(2) The technical approach. : 

There are two pure approaches to forecasting foreign exchange rates: (1) The fundamental approach.(2) The technical approach.

The fundamental approach is based on a wide range of data regarded as fundamental economic variables that determine exchange rates. These fundamental economic variables are taken from economic models. Usually included variables are GNP, consumption, trade balance, inflation rates, interest rates, unemployment, productivity indexes, etc. In general, the fundamental forecast is based on structural (equilibrium) models. These structural models are then modified to take into account statistical characteristics of the data and the experience of the forecasters. : 

The fundamental approach is based on a wide range of data regarded as fundamental economic variables that determine exchange rates. These fundamental economic variables are taken from economic models. Usually included variables are GNP, consumption, trade balance, inflation rates, interest rates, unemployment, productivity indexes, etc. In general, the fundamental forecast is based on structural (equilibrium) models. These structural models are then modified to take into account statistical characteristics of the data and the experience of the forecasters. Fundamental Approach: FUNDAMENTAL APPROACH

Practitioners use the fundamental approach to generate equilibrium exchange rates. The equilibrium exchange rates can be used for projections or to generate trading signals. A trading signal can be generated every time there is a significant difference between the forecasted exchange rate and the exchange rate observed in the market. If there is a significant difference between the forecast rate and the actual rate, the practitioner should decide if the difference is due to a mispricing or a heightened risk premium. If the practitioner decides the difference is due to mispricing, then a buy or sell signal is generated. : 

Practitioners use the fundamental approach to generate equilibrium exchange rates. The equilibrium exchange rates can be used for projections or to generate trading signals. A trading signal can be generated every time there is a significant difference between the forecasted exchange rate and the exchange rate observed in the market. If there is a significant difference between the forecast rate and the actual rate, the practitioner should decide if the difference is due to a mispricing or a heightened risk premium. If the practitioner decides the difference is due to mispricing, then a buy or sell signal is generated. Fundamental Approach: Forecasting at Work

There are two kinds of forecasts : 

There are two kinds of forecasts In-sample Out-of-sample The first type of forecasts works within the sample at hand, while the latter works outside the sample. In-sample forecasting does not attempt to forecast the future path of one or several economic variables. This sample forecast method uses today's information to forecast what today's spot rates should be. Thus the forecast will be within in the sample. The fundamental approach generates an equilibrium exchange rate. The foreign exchange rate in-sample fundamental forecasts are interpreted as equilibrium exchange rates. Equilibrium exchange rates can be used to generate trading signals.

On the other hand, out-of sample forecasting attempts to use today’s information to forecast the future behavior of exchange rates. That is, we forecast the path of exchange rates outside of our sample. In general, at time t, it is very unlikely that we know the inflation rate for time t+1. That is, in order to generate out-of-sample forecasts, it will be necessary to make some assumptions about the future behavior of the fundamental variables. : 

On the other hand, out-of sample forecasting attempts to use today’s information to forecast the future behavior of exchange rates. That is, we forecast the path of exchange rates outside of our sample. In general, at time t, it is very unlikely that we know the inflation rate for time t+1. That is, in order to generate out-of-sample forecasts, it will be necessary to make some assumptions about the future behavior of the fundamental variables.

Technical ApproachThe technical approach (TA) focuses on a smaller subset of the available data. In general, it is based on price information. The analysis is "technical" in the sense that it does not rely on a fundamental analysis of the underlying economic determinants of exchange rates or asset prices, but only on extrapolations of past price trends. Technical analysis looks for the repetition of specific price patterns. Technical analysis is an art, not a science. : 

Technical ApproachThe technical approach (TA) focuses on a smaller subset of the available data. In general, it is based on price information. The analysis is "technical" in the sense that it does not rely on a fundamental analysis of the underlying economic determinants of exchange rates or asset prices, but only on extrapolations of past price trends. Technical analysis looks for the repetition of specific price patterns. Technical analysis is an art, not a science.

Exchange Rate Forecast: Models : 

Exchange Rate Forecast: Models Purchasing Power Parity (PPP) Model Uncovered Interest Rate Parity (UIP) Model Random Walk Model

Purchasing Power Parity (PPP) Model : 

Purchasing Power Parity (PPP) Model Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP.

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. : 

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver.

There are three caveats with this law of one price : 

There are three caveats with this law of one price As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and services in both countries. (3) The law of one price only applies to tradable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.

How is PPP calculated? The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consumer very different sets of goods and services, making it difficult to compare the purchasing power between countries. : 

How is PPP calculated? The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consumer very different sets of goods and services, making it difficult to compare the purchasing power between countries.

Uncovered Interest Rate Parity (UIP) Model : 

Uncovered Interest Rate Parity (UIP) Model A parity condition stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries’ currencies. If this parity does not exist, there is an opportunity to make a profit. "i1" represents the interest rate of country 1"i2" represents the interest rate of country 2"E(e)" represents the expected rate of change in the exchange rate.

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For example, assume that the interest rate in America is 10% and the interest rate in Canada is 15%. According to the uncovered interest rate parity, the Canadian dollar is expected to depreciate against the American dollar by approximately 5%. Put another way, to convince an investor to invest in Canada when its currency depreciates, the Canadian dollar interest rate would have to be about 5% higher than the American dollar interest rate.

Random Walk Theory : 

Random Walk Theory The theory that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement.

In short, this is the idea that stocks take a random and unpredictable path. A follower of the random walk theory believes it's impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time - in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments.This theory raised a lot of eyebrows in 1973 when author Burton Malkiel wrote "A Random Walk Down Wall Street", which remains on the top-seller list for finance books. : 

In short, this is the idea that stocks take a random and unpredictable path. A follower of the random walk theory believes it's impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time - in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments.This theory raised a lot of eyebrows in 1973 when author Burton Malkiel wrote "A Random Walk Down Wall Street", which remains on the top-seller list for finance books.