EXCHANGE RATE FORECASTING

Prior to the introduction of flexible or floating exchange rate as the Bretton

woods system. The chief features of the Bretton Woods system were an
obligation for each country to adopt a monetary policy that maintained the
exchange rate by tying its currency to gold ($ 35 per ounce).
Under the Bretton Woods system, central banks of countries other than the
United States were given the task of maintaining fixed exchange rates between
their currencies and the dollar. They did this by intervening in foreign
exchange markets. If a country's currency was too high relative to the dollar,
its central bank would sell its currency in exchange for dollars, driving down
the value of its currency. Conversely, if the value of a country's money was
too low, the country would buy its own currency, thereby driving up the
price.
The Bretton Woods system lasted until 1971. By that time, inflation in the
United States and a growing American trade deficit were undermining the
value of the dollar. Americans urged Germany and Japan, both of which had
favorable payments balances, to appreciate their currencies. But those nations
were reluctant to take that step, since raising the value of their currencies
would increases prices for their goods and hurt their exports. Finally, the
United States abandoned the fixed value of the dollar and allowed it to "float"
-- that is, to fluctuate against other currencies. The dollar promptly fell. By
1973, the United States and other nations agreed to allow exchange rates to
float.
Under floating exchange rate regime a country's exchange rate is set by the
foreign-exchange market through supply and demand for that particular
currency relative to other currencies. Thus, floating exchange rates change
freely and are determined by trading in the forex market.
Since the advent of flexible exchange rate system in 1973, exchange rates have
become increasingly more volatile and erratic. At the same time the scope of
business activities has become highly international. Consequently many
business decisions are made based on forecasts. Forecasting exchange rates are

a matter of vital importance for currency traders who are actively engaged in
speculation, arbitrage and hedging in the foreign exchange markets. Corporate
decisions will be based on these forecasts.
Forecasting is very necessary and common in our times, people take
forecasting into consideration when they make economic decisions. These
decisions then influence the direction in which the economy will move. Cash
flows of all international transactions are affected by the expected value of the
exchange rates , therefore forecasting exchange rate movements is very
important for businesses , investors and policy makers .
Forecasting is required for the following decisions:

Short term financial and investment decisions require exchange rate

forecasting to determine the ideal currency for borrowing money and to
allocate the one that maximizes the return on an investment.

Capital budgeting decisions need forecasting of exchange rate to determine

the expected cash flows and make an accurate decision for these foreign
investments.

Long term financial decisions require forecasting of currencies to decide from

where to borrow money (which will reduce the cost if currency depreciated).

Earnings assessments need to forecast the foreign currency in which the

earnings are coming and decide if earnings are going to be remitted back to
the parent company or invested abroad.

Transaction risks, the risks that comes from a fluctuation in the exchange rate
between the time the contract is signed and when the payment is received
.with most of the exchange rates floating nowadays, they can vary easily as
much as 5% in a week.

FORECASTING TECHNIQUES

FUNDAMENTAL APPROACH
a. Suitable for long term investments
This approach is mainly suitable for long term investments, its used keeping
in mind long term motives It forecasts exchange rates after considering the
factors that give rise to long term cycles. This approach is based on the
premise that the true worth of a currency will eventually be realized. Hence,
this approach is suitable for long term investments.

b. Considers Macroeconomic variables

Elementary data related to a country, such as GDP, inflation rates,
productivity indices, balance of trade and unemployment rate are taken into
account.
c. Based on Econometric Model
Based on econometric models used by economists to forecast future
development in the economy. Econometrics measure past relationships among
variables for example consumption spending, household income etc. It
measures how changes in the variables will affect the future.

FUNDAMENTAL APPROACH TECHNIQUES

SHORT TERM HORIZONS
1. ASSET CHOICE MODEL
This model tries to identify why one currency is better over the other
a. Interest rates prevailing in the country for borrowing and lending i.e.
current as well as anticipated

b. Political risks prevailing in the country , for example change in the

government , political unrest affect the exchange rates as well as reduce
investments in the country
c. Safe haven effects an investment that is expected to retain its value or
even increase its value in times of market turbulence. Safe havens are
sought by investors to reduce exposure to losses during bad markets.
For example gold is considered as a safe haven.
LONG TERM HORIZONS
1. PURCHASING POWER PARITY MODEL
PPP is one of the oldest exchange rate models introduced in the 16th century.
This model is useful for forecasting in the long run. PPP shows how much
money would be needed to purchase the same amount of goods and services
in two different countries.
Exchange rates are considered in equilibrium as per PPP when purchasing
power is same in two countries.
The Big Mac Index is published by The Economist as an informal way of
measuring the purchasing power parity (PPP) between two currencies. The
big Mac index helps identify which currency is overvalued or undervalued. For
example, the average price of a Big Mac in America in July 2014 was $4.80; in
China it was only $2.73 at market exchange rates. So the "raw" Big Mac index
says that the Yuan was undervalued by 43% at that time.

ABSOLUTE PURCHASING POWER PARITY

This concept says that the exchange rate between two countries will be
identical to the ratio of the price levels for those two countries. This concept
is derived from a basic idea known as the law of one price, which states that
identical products produced by two or more countries, the price of the
product should be same no matter which country produces it.

For example in US a basket of apples cost $100 and in India its for
1000 therefore E (0) =P ( )/P ($)
= 1000/$100
Hence, 10 = $1
RELATIVE PURCHASING POWER PARITY
This relates to the change in two countries expected inflation rates to the
change in their exchange rates. Inflation reduces the real purchasing power of
a nations currency.
If a country has an annual inflation rate of 10% that means the purchasing
power of the country will reduce by 10% that is the citizens will be able to
purchase 10% less goods at the end of the year.
Relative purchasing power parity examines the relative changes in price levels
between two countries and maintains that exchange rates will change to
compensate for inflation differentials.

Relative PPP indicates that,

a. Domestic currency will depreciate if inflation in the domestic country is
more than the foreign country.
b. It will depreciate to the extent of inflation differential.
For example: expected annual rate of inflation in India is at 6% per year while
in US is at 3%. Hence Indian rupee will depreciate by 3 % in the year.

2. INTERNATIONAL FISHER EFFECT

International fisher effect states that an estimated change in the current
exchange rate between any two currencies is directly proportional to the

difference between the two countries' nominal interest rates at a particular

time.
International fisher effect is a combination of fisher effect and relative
purchasing power parity.
Fisher effect states that Real Rate of Interest = Nominal rate of interest
expected inflation.
Therefore as per IFE increase in inflation will lead to increase in interest rates
therefore it will lead to depreciation in the currency of the country and vice
versa.
For example : For example, if the interest rate of country A is 10% and that of
country B is 5%, then the currency of country B should appreciate roughly
5% compared to the currency of country A.
TECHNICAL APPROACH
Technical analysis involves use of historical data to estimate future values, this
approach ignores news and various economic, political variables that affect the
value of foreign exchange for example increase in value of rupee can lead to
reduction in IT sector margins. Such news is generally not considered in
technical approach.
Technical approach relies on charts and chart patterns, along with investor
sentiment. For example if investors sentiment is bullish the price will go up.
Technical analysis is based on the premise that:
1. History repeats itself
2. Price moves in trends
3. Price discounts itself
Technical approach is more useful on short term basis by currency traders.
Examples of technical approach are:
a) Moving averages

Moving averages is calculated as average of securities price over a

period of time. For example 13 day SMA.
MA crossovers indicate increase or decrease of price. Crossover of a
SMA over LMA indicates strength in price, and vice versa.

b) Bollinger Band
Bollinger band is made of SMA two standard deviations above and
below the SMA.
When price moves above the upper band its overbought it shows
weakness in the security.
When price moves below the lower band its oversold this indicates
future strength in the currency.

CONCLUSION
To conclude exchange rate forecasting has certain theoretical flaws like PPP
cannot be applied in real world as it does not take tariffs and various other
frictions in consideration.
On long term forecasts may be viable, not on short term.
The users must supplement to prediction with his/her own analysis and
intuition,