Answer to Question #230397 in Economics for hyatt

Question

The forecasting of exchange rates is a tricky process that requires both subjective as

well as analytical inputs. Having said that it is an essential skill for the manager of an

internationally operating firm.There are theoretical methods as well as statistical/analytical

methods to forecast the same. Describe various techniques of forecasting the exchange

rates, as well as, your recommendation on which method would you use in forecasting the forex rate, lets say forecasting Indian rupee per US dollar.

Answer 1

3 ways to forecast currency changes are:

1. The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. The PPP forecasting approach is based on the theoretical law of one price, which states that identical goods in different countries should have identical prices.
2. The relative economic strength approach looks at the strength of economic growth in different countries in order to forecast the direction of exchange rates. The rationale behind this approach is based on the idea that a strong economic environment and potentially high growth are more likely to attract investments from foreign investors.
3. Another common method used to forecast exchange rates involves gathering factors that might affect currency movements and creating a model that relates these variables to the exchange rate. The factors used in econometric models are typically based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.