Forecasting foreign currency exchange rates
1 Introduction
If the currency of a country is allowed to float, then the exchange rate against other currencies will fluctuate.
In this chapter we will consider the factors that affect exchange rates and look at two arithmetical approaches to attempting to forecast a future exchange rate.
2 Factors affecting the exchange rate
The exchange rate between two currencies is primarily determined by supply and demand for the currencies.
The supply and demand are in turn influenced by factors including:
the rates of inflation in the two countries
the level of interest rates in the two countries
economic and political prospects
the balance of payments
3 Purchasing Power Parity
One important influence on exchange rates is the relative inflation rates in the two countries.
The Purchasing Power Parity theory uses inflation rates to predict the future movements in exchange rates. It states that identical goods should sell at the same price when converted into the same currency. As the local currency prices change with inflation, then the exchange rates should change to keep the relative price the same.
An item currently costs £100 in the UK.
The current exchange rate is $/£ 1.50.
The rates of inflation are 2% p.a. in the UK and 4% p.a. in the US.
(a) what will be the price of the item in 1 years time in the UK and in the US
(b) as a result, what will be the exchange rate in 1 years time?
The above can be expressed as a formula, which is given to you in the examination:
The exchange rate is currently $/£ 1.70
The inflation rate in the US is 5% p.a. and in the UK is 2% p.a..
What will the exchange rate be in:
(a) one years time
(b) two years time
The exchange rate is currently ¥ / £ 2030
The inflation rate in Japan is 4% p.a. and in the UK is 8% p.a..
What will the exchange rate be in:
(a) one years time
(b) two years time
4 The Fisher effect
The Fisher effect looks at the relationship between interest rates and expected inflation rates.
The actual rate of interest is said to be made up of two parts – the real required rate of return (or the real interest rate), together with a premium for inflation.
The actual interest rate will therefore increase or decrease with increases or decreases in the rate of inflation.
The following formula relates the interest rate to the inflation rate, and is given to you in the examination:
(1 + i ) = ( 1 + r ) × ( 1 + h )
where:
i is the actual interest rate (or nominal or money rate)
r is the real interest rate
h is the inflation rate
5 Interest Rate Parity
This theory uses relative interest rates to predict the future exchange rate.
The formula is given in the exam and is as follows:
You will see that it is exactly the same as the Purchasing Power Parity formula, except that it uses interest rates instead of inflation rates.
The formula is used in exactly the same way.
It is, of course, unlikely that either Purchasing Power Parity or Interest Rate Parity will predict the exchange rate exactly, because there are so many other factors that will influence it.
However, you will see in the next chapter that forward exchange rates are calculated using the Interest Rate Parity formula.
The two formulae are the same shape and are told apart only by what you put into them: inflation rates for purchasing power parity, interest rates for interest rate parity. A statement that exchange rates move over time to offset a difference in inflation between two countries is purchasing power parity. The Fisher effect in this chapter is a different thing — it links one country’s interest rate to its own inflation rate, and says nothing about an exchange rate.
Forecasting foreign-currency exchange rates
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