It is important to most entities to have a workable method to aid in forecasting forex rates. Regardless of whether you are a large corporation or an individual trader, a practical method will be vital in minimizing your risks and maximizing returns on trades. There are many different methods available for use and one is not superior to the other, but some are more popular than others.
Econometric Models
This is a common method where you collect information that will have an effect on the shift in particular foreign currencies. If you make effective use of this information, you will be able to draft a model to use this data and other factors to do forecasts. You should use basic economic theories along with other variables that you think are relevant in their effect on the currency rate.
An example of this is if you have done research where you determine that the interest rate and gross domestic product growth differences between your currency pair will be affected, you should build these two variables into your calculations.
This method of calculation can become quite time intensive. The addition to the calculation of external factors may make this forecasting method extremely complex. The main advantage linked to this method is that once it has been set up and is operating smoothly, it is very easy to use. Any new data that is obtained can quite easily be added which will give you the opportunity to do fast forecast calculations.
Purchasing Power Parity
This method of forecasting is one of the most popular methods used as it is often quoted in economic textbooks. The Law of One Price is the basis of this method. This economic law states that items that are identical should be sold at identical prices in different countries. The idea that it is based on is that a standard commodity such as a pencil in the U.S. should carry the same cost in Europe. This should be the net cost after the exchange rate differences have been accounted for, but it excludes costs of transport and administration fees. This implies that a person should not be able to purchase those pencils in one country and then have the opportunity to sell them at a profit in another country.
This method is based on the premise that the currency rate should be changed to absorb the price changes brought about by inflation. An example is that if the price is set to go up by 5% in the U.S. and 2% in Europe, the inflation variance between the two countries, by calculation, will be 3%. This is indicative of a much faster price increase in the U.S. and according to this method of calculation indicates that the US dollar should fall by 3% to keep the prices equal in the respective countries.
There are several other methods that economists use regularly. Your responsibility is to find the one that works best for your trading style, adjust it if you feel that it is necessary, and use it effectively.
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