How do you forecast exchange rates?
Getting competitive, best exchange rates can help save you a lot of money. Whether you are a tourist, expat, financial trader, or businessman, it is very important to know how to forecast the exchange rates, to minimise risks and maximise returns.
Exchange rates are linked to global markets and they change on a daily basis. While predicting their exact rate with accuracy is not possible, you can to a certain extent forecast its direction by understanding the following.
Purchasing Power Parity (PPP)
Purchasing Power Parity is an economic theory which works on the principle that identical goods in different countries should have identical prices. For e.g. if a pair of Nike shoes costs X dollars in a particular country then it has to cost the same X dollar in a different country after the currency conversion.
The Economist Magazine has a fun way of predicting the exchange rates called the Big Mac Index. This index considers the cost of the Big Macdonald Burger in different countries to predict the exchange rate movement. Consider the present scenario; one USD is equivalent to 3.67 AED currently. In future if one Big Mac Burger were to cost one dollar in USA but the same burger is costing 4 AED in the UAE, then the rule says that the AED will depreciate in the long run to 4 AED per dollar.
Relative economic strength
If the economic strength of a nation is strong (like strong growth rate, manufacturing sector growth, low interest rate etc.) then the global investors would want to invest in these countries via their financial markets through stocks, government bonds etc. When there is a demand from global investors the currency would appreciate. This rule is a good predictor of the overall upward/downward trend of currencies.
If you are a financial investor looking to make money from exchange rate fluctuation then you can use econometric models which take into consideration different parameters like GDP growth rate, interest rate, inflation etc, and assign them particular values to build an equation around them. This helps get an exact number for future exchange rate.
Time series model
This method is purely technical and is not based on any economic theory. A popular time series approach is called the Autoregressive Moving Average (ARMA). This method is based on the idea that past behaviour and price patterns can be used to predict future patterns. All it needs is a time series of data which can be fed to the computer.
Another easy way to avoid the exchange rate fluctuation is to use a travel card that lets you lock in exchange rates when they are favourable. You can use the locked rates later, when the currency rates head in an unfavourable direction.