Methods Of Forecasting Exchange Rates

International Financial Management 943

Methods of Forecasting Exchange Rates

There are various methods of forecasting the exchange rates between two or more countries’ currencies (Alvarez-Diaz, 2008). Prediction of exchange rates between countries helps to minimize risks while maximizing the returns. Some of these methods includes purchasing power parity (PPP), relative economic strength approach, econometric models, and time series models, among others.

The forward method uses purchasing power parity (PPP) method where the only consideration is the inflation rates between the two countries (Taylor, 2003). This approach depends on the theoretical law that identical goods will cost the same in different countries excluding the after taking into consideration the exchange rates and excluding the transaction and shipping cost. Based on this, the PPP approach forecasts changes in exchange rates to offset price changes due to inflation only.

A time series model is kind of a mathematical model developed over time and based on various variables as may have been identified practically over time. Some of these variables could be interest rates, business security, assurance for returns, etc. This may be more accurate than just assuming inflation rates only.

The Leader in this particular firm must have had experience that the forward rates estimates was a low estimation of the rates. She must have had developed some mathematical (e.g. time series models) models to estimate the exchange rates from experience. This kind of model may have included data collected over a long period over her working career and hence a better estimation criterion for exchange rates than the one, which merely assumes changes are only due to inflation rates. These ...

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...e higher your risk tolerance, the more you may invest in higher-risk securities offering the potential for greater returns. While there is no foolproof strategy to ensure you are making safe investments, financial advisors are always there to help an investor make informed decisions.

In the current scenario, both investments will have atleast the same returns and hence it will be worthy selecting an investment which has equal or more returns with reduced risk. The speculative investment in the current scenario may be more devastating in terms of returns if, for example, the speculative rates does not happen and instead the forward rates are used at the end of the day. While in this case the investor will still make profit at 2.7%, it will not be as expected at 6.65% while an alternative investment option is available where there is a guaranteed 6.65% or more returns.