The Power of Forecasting Currency Changes

Currency traders will want to have the ability to predict currency changes when trading forex.  Understanding the forces that drive foreign exchange rates can help traders make better trading decisions while minimizing the inherent risks.  Although there are many methods that claim to predict currency changes, none have been able to support that claim.  However, if traders know how to properly use a combination of prediction methods, they may be able to increase their forex trading success.

The PPP Method

PPP, or purchasing power parity method is quite possibly the most popular foreign exchange rate forecasting approach.  This method is based on the Law of One Price, which says that the same good from a variety of countries should have the same price.  One of the most famous uses of the PPP is the Big Mac Index.  This humorous index tries to measure if a currency is overvalued or undervalued based on the price of a Big Mac in different countries.  Because Big Macs are pretty much the same in all the countries that have them, the differences in prices can indicate the dynamics of a country’s currency.

The Relative Economic Strength Method

The relative economic strength method uses the economic growth of a country to attempt to predict the direction of foreign exchange rates.  The theory behind this method is that a strong economy and potential for growth will likely draw in investors from foreign countries.  This would have an impact on the currency of that country because foreign investors first have to purchase the currency of that country.  This creates a demand and the currency will likely appreciate.  This method uses a more general viewpoint of all investment flows rather than the relative strength of the economy between countries.  This will give investors an idea of whether the currency will depreciate or appreciate as well as an idea of the strength of the direction the currency is moving in.

The Use of Models

Another widely used method to forecast currency changes is the econometric models method.  This method allows traders to create a model of factors that they believe affect foreign exchange rates.  These factors are generally founded in economic theory but anything may be added to the model if the trader believes it influences the forex market.  The time series model is not based on economic theory but is based on historic price patterns that are used to forecast future price patterns and behaviors.  The data that is used for this approach can be gathered from historic foreign exchange data.  Traders can then easily put this information into a computer program to get an estimate of parameters.  This will create a time series model that traders can use to predict future currency prices.

In Conclusion

It is difficult to forecast foreign exchange rates but there are methods that can help investors determine future prices and changes.  When traders have a better understanding of how currency exchange rates are affected, they will have a much more successful forex trading career.

Have you used any of these models to forecast currency changes?  Which methods would you recommend to other traders? Please leave your comments below.