Four Methods for Predicting Currency Exchange Rates
For many traders, attempting to predict currency exchange rates is an exercise in futility, since they are determined by factors beyond the trader’s control. In fact, what traders do is try to look for price trends that could signal profitable trades. However, there are some methods that many traders swear by. While these methods may not give you the exact value of exchange rates in the future, they will indicate price movements which make them useful in making trading decisions.
Here are some of the most popular predictive techniques that you can try for yourself. Note that these methods are rarely used on their own, but in conjunction with other techniques to provide a more accurate and complete picture.
- Purchasing Power Parity. This economic theory states that similar products in different countries should have essentially the same price, and that when they don’t, currency exchange rates adjust in order to offset price changes due to inflation. For example, if prices in France are expected to increase by 5% over the course of the year, while those in Italy are seen to rise by 3% over the same period. This means that the inflation rate differential between the two countries is 2% and that prices in France would have to depreciate by the same percentage to keep prices relatively equal. You can even use a formula that will allow you to approximate what the exchange rate should actually be in both countries.
- Relative Economic Strength Index. Since currency exchange rates are seen as indicators of the underlying health of an economy, this index attempts to forecast exchange rates by looking at all the factors in the economy that can draw investors. For example, if the economy is seen to enjoy high economic growth, it can interest investors in bringing their money into the country. Or when interest rates are high compared with other countries, investors can come in, drawn by the possibility of taking advantage of these rates to make a profit. When investment flows into the country, it creates demand for the local currency, which causes the exchange rate to appreciate. This approach gives you a general idea as to whether a particular currency is set to appreciate or depreciate as well as how strong the movement is going to be.
- Econometrics. This approach involves looking at the various factors that can influence the exchange rate, from interest rates to Gross Domestic Product growth rates, and then creates a mathematical model that will predict the exchange rate over the course of the following year. This approach is labor-intensive and requires a working knowledge of advanced mathematics, but once you have created the model, you can not only use it to make predictions, you can also change the variables to create new forecasts.
- Time Series. The theory behind this approach is that past price movements can be used to make a prediction as to what future ones will be. All you need is to look at the time series of particular currency exchange rates and then create a predictive model based on these.
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