7 Common Ways to Forecast Currency Exchange Rates
The question of how to forecast exchange ratesis one of the most frequently asked in Forex trading. Although many methods can be used to forecast exchange rates, not all of them are simple. Some of them require large amounts of data or complex technical knowledge. However, the ones that a trader of any level can use are covered in this article.
Factors That Affect a Currency Rate
There are some factors that form the basis of the different FX rate forecastmethods, and these factors are:
Government Stability
Changes in government, in its policy, and even coups and wars can affect the exchange rate. Usually, wars lead to the depreciation of a domestic currency, while presidential elections may cause increased price volatility.
Economic Reports
The economy of any country determines how strong a domestic currency will be. That is: a growing economy indicates opportunities for appreciation. Conversely, economic problems will lead to a currency’s decline.
However, the underlying economy is influenced by many factors including inflation, unemployment rate, and Gross Domestic Product (GDP). Therefore, to analyse the value of a currency, traders may use these metrics.
Central Bank Monetary Policy
High inflation and unemployment rates are some of the economic issues that any country may face, and monetary policy aims to manage them.
Monetary policy includes various tools that allow a central bank to stabilise an economy. For instance, it can foster economic growth by increasing the money supply.
An interest rate decision is a common factor for predicting exchange rates. The rule is: when the central bank raises the interest rate, the domestic currency usually appreciates. When it cuts the rate, the country’s legal tender usually depreciates.
Ways to Predict Exchange Rates
Many methods have been created to forecast currency price direction, check some of them below.
1. Fundamental Analysis
This forecast method includes all the factors mentioned above, such as monetary policy, domestic and foreign government policy, and global economic and political conditions. Knowing the factors that may affect a currency and constantly following economic releases and news, a trader has the potential to forecast its value.
2. Technical Analysis
This approach doesn’t consider the influence of external forces. Rather, it uses patterns discovered from historical price data and statistics to forecast future movement. Indicators, trendlines, and candlestick and chart patterns are essential instruments of technical analysis. You could use the TickTrader platform to discover technical analysis tools.
These were common methods for currency exchange predictions. Below you will find five macroeconomic approaches you may implement when analysing currencies.
3. Relative Economic Strength
It’s already been established that numerous economic factors make up FX rate forecasts. However, many traders are unaware that these factors also interact with each other.
For example, a country’s inflation or unemployment rate can give traders an idea of what its monetary policy will be like. So, traders can observe these economic factors. By doing this, they get an idea of what’s going to happen to the domestic economy and exchange rates.
Of course, this currency projection method isn’t the most accurate out there. It won’t provide any numbers regarding the new currency value; however, it will be possible to tell if the currency increases or decreases in the short term.
4. Econometric Model
This FX rate forecast method is personal, as it differs between traders. Here, Forex traders select whatever metrics they believe influence the currency market the most. Comparing economic conditions in two countries, traders could forecast an exchange rate.
For example, considering the EUR/USD pair, a trader could compare interest rates in the EU and the US, GDPs, and the unemployment rate. By determining differences, they may predict the direction of a pair’s rate.
5. Purchasing Power Parity (PPP)
While the relative economic strength approach gives a direction for currency movement, purchasing power parity says what the rate is supposed to be.
This method asserts that the price of goods and services should be equal, regardless of the country. If there are any differences in price, a trader can calculate the suitable exchange rate that will make goods or services cost the same.
For example, a table in France costs €50, while that same table is priced at $80 in the USA. Considering the difference in price, a trader can determine the EUR/USD pair’s value. To buy the same table in France and the USA, the EUR/USD rate must be $1.6.
Knowing the required exchange rate, traders might determine whether a currency is overvalued or undervalued. With this, they can make a guess at future currency values.
6. Interest Rate Parity (IRP)
The interest rate parity is quite similar to purchasing power parity. But PPP focuses on the prices of goods, while IRP focuses on currency and interest rates.
The general concept of this model is that the differential between interest rates should equal the differential between spot and forward exchange rates.
So, if an investor exchanges a domestic currency for a foreign one and invests it in a foreign economy or uses a domestic currency to invest in the home country and converts the proceeds from the investment into a foreign currency, their earnings will be the same in both cases.
The Interest Rate Parity method implies the following formula:
Where:
? F0 = Future exchange rate
? S0 = Current (spot) exchange rate
? ia = Interest rate of the country of the quote currency
? ib = Interest rate of the country of the base currency
The theory says that a trader should calculate the current currency pair rate and the interest rates of both countries to determine the future exchange rate of a currency pair.
7. Balance Payment Theory
This foreign exchange model determines future currency values by considering a country’s rate of imports and exports. The theory behind this method is that the domestic currency appreciates when it exports more than it imports and depreciates when the opposite occurs.
Final Thoughts
One possible way to minimise risks lies in foreign exchange rate forecasting. There are many ways to go about this, including fundamental and technical analysis, relative economic strength, econometric models, and purchasing power parity. Every trader chooses whichever one works best for them or uses multiple methods to perform comprehensive research.
You can try a demo account at FXOpen to practise exchange rate forecasting without risks.
Read more: https://fxopen.com/blog/en/7-common-ways-to-forecast-currency-exchange-rates/
Text source: Forex Trading Blog
