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predicting trends in foreign exchange rates

Page history last edited by Brian D Butler 11 years, 9 months ago








Predicting future FX rates...


ie. "Speculating" on future trends


The key driver to determine whether a currency appreciates or depreciates in the market is CONFIDENCE.  If traders continue to have confidence in the economic growth / stability of a country, then they will continue to demand that currency.  For example, when US economy is slowing down, and the Fed cuts interest rates, the indication is less confidence in the sustainability of the US economy, so less confidence should yield a depreciation of the currency.


The two main drivers, besides "confidence" that effect FX rates are interest and inflation, but always remember: "interest" forces are always faster / stronger than "inflation" forces.  Because the financial system moves quickly to take advantage of interest, but the prices of common goods adjust more slowly.   With that said....here is a discussion about many variables that work together to help set FX rates. 


Note:  this page is for speculating, and guessing the future FX rates of a currency.  If you are looking for  Other currency-related pages from KookyPlan:


  • Currency (for academic issues such as "what is FX currency?, and "what is a fixed / floating regime? etc..)
  • foreign currency trading  (for practical tips, and current exchange rates)
  • currency hedging  (for protecting yourself / your company against currency markets)




Table of Contents:




Predicting future trends:


#1.  What is today's currency exchange rate?  What direction will it move in the future?  How can you figure that out?


Choices:  ask currency trader what he / she thinks....Or, look at past trends assuming they will continue....or, use fundamental economic theories to predict the future...or....???



Company managers STOP...


Before you continue, you should first look at our section on currency hedging, with warnings about why you should hedge and not speculate on the currency markets. 


The FX market is so complex, it is nearly impossible to predict what will happen.  That said, many people spend a lifetime trying to predict future movements of FX rates.  The trouble is that FX rates are basically set by an open market of people trading based on their expectations, and their subjective valuations of different currencies. As a result, the FX market can at times seem irrational, and valuations are often not based on the underlying economics fundamentals.




Chartist Method:


the chartist method is very popular in the short term (with traders)


Look at the trend over the past hour or two...and bet that it will continue.  the chartist method is VERY popular in the extremely short term.  analysts watch for patterns, or trends, and then make bets based on those trends.  they look for "support levels", dips, troughs, peaks, etc...


If the time frame is longer than an hour or two (maybe up to a day or two)...the chartist method should NOT be used


  • This technique is also called "technical trading." 
  • This is the most common technique for daily trading in the foreign Currency market 
  • Use graph, chart. 
  • Very little use of economic fundamentals 
  • Look at historical trends, and speculate that currencies will follow similar patterns.  Try to guess when a rising currency will fall. 
  • Over time, this method HAS proven to make more money than using economic fundamentals...so people use it allot. 








Economic Theories (to predict trends)



If you compare two interest rates of two countries, then the one with the HIGHER interest rate will have the (LOWER) currency depreciate in the futures (and forward) markets.   Imagine if the Japanese Yen had a lower rate of return (than the US dollar) for an investment, then you would expect that investors should be compensated for that lower return by appreciation of their currency...or else...no one would keep their money in Japanese Yen...everyone would convert it to USD.  So, the currency with the lower interest rate must have appreciation, and the currency with the higher interest rate must see depreciation. (for more discussion, see interest rate parity).




Interest effects


FX markets are in equilibrium when interest rates on deposits of all currencies offer the same expected rate of return. If the interest rates are the same in two different countries, then people will value the deposits the same, and will not move them. 


Example: assume the US interest rate is 12%, the Euro interest is 8%, but the dollar is expected to depreciate against the Euro by 6% per year...that means that expected rate of return on Euro deposits would be higher than the expected rate of return on Dollar deposits.


How will this affect the FX market? In theory, this would result in people trying to sell their dollar deposits to buy Euros. The Dollar should depreciate. The important point to remember here is that the balance would only come when the expected rate of return on both Dollar deposits and Euro deposits was the same.


What rates to use?


The best interest rates to use in predicting exchange rates is the Eurocurrency rate. This is the rate on wholesale interbank deposits in the London market. That way, the country risk, the bank risk, the tax treatment, and all other considerations are equal, except for the currency of denomination. Therefore, you have the pure interest rate difference as the tool for creating the forecast.


  • Example: If you want to predict future USD $ / Euro rates, you would look to the London Interbank Offer rates (LIBOR) on USD deposits, and compare that with London Interbank Offer rates on Euro Deposits.


Libor Rates:

01/2009.  source:  http://www.tradingeconomics.com/World-Economy/LIBOR-Rates.aspx


Country Central Bank Rate 3 Month LIBOR 1 Year LIBOR 2 Year LIBOR 10 Year Yield
Australia 4.25% 4.63% 4.51% 3.57% 4.42%
Brazil 13.75% 12.62% 8.12% 11.67% 13.61%
Canada 1.50% 1.80% 2.26% 1.01% 2.55%
China 5.31% 5.31% 5.31% 5.40% 5.94%
Euro Area 2.00% 2.69% 2.84% 2.44% 3.64%
India 5.00% 4.13% 4.37% 4.36% 5.34%
Japan 0.10% 0.78% 1.05% 0.73% 1.31%
New Zealand 5.00% 5.54% 5.44% 4.28% 5.01%
Russia 13.00% 21.80% 28.50% 27.16% 8.35%
Switzerland 0.50% 0.60% 1.05% 0.97% 2.57%
United Kingdom 1.50% 2.38% 2.71% 2.29% 3.47%
United States 0.25% 1.26% 1.86% 1.30% 2.54%




Interest Rate Parity & the Fisher Effect


see interest rate parity


The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the real exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing.


To estimate future changes in FX rates...look at the difference in interest rates between the two countries. The country with the higher interest rate will see depreciation (their currency will depreciate). This is the opposite of what you expect. Normally, you hear that if the Fed raises interest rates, then the dollar will strengthen (appreciate) as investors will put money into the US in order to get the higher return. So, you would expect the dollar to appreciate. It does, but only in the very short term. Then, in the longer term, it will do the opposite, and depreciate. If you could have predicted the raise in interest rates, then you could have made money in the short term by investing in the currency before its quick appreciation, but as others pour in, the market will react, and it will be difficult to realize the gains in the future. What happens is that the forward / Futures market will price in the new information, and will drive the currency down. See the discussion below about "Interest rate parity in the Forward Market" for an explanation.



Formula to predict currency changes:


Exchange rate (future) = Exchange rate today * (1 + Interest rate foreign /  1 + interest rate domestic)


Spot rate (expect) = Spot rate (today) *  [ ( 1+INT for) / (1+INT dom)]


Spot rate (expect) = Spot rate (today) *  [ interest / interest ]....


how to know which currency to put in the nominator / denominator?  Just match them up.  If the Spot rate today is expressed in USD / Euros....then put US interest rate on top, and the EURO interest rate on the bottom.


Example:   What is the expected Spot rate in 1 year if todays Spot Rate is = 1.3426 USD / Euro?   Interest in US = 2.93%,  Interest in Europe = 2.26% (international money market rates):


Spot rate expect =  1.3426  USD / EU * ( US 1.0292 /  EU 1.0226013) = 1,3512635 USD / EU (which is saying that the USD will depreciate)


Whether or not the actual exachange rate will actually move according to this formula is anyones guess.  But, this formula is EXTREMELY  important because it is used (must be used) to calculate the forward (and future) exchange rates.  If the formula is not exactly this...then there will be an arbitrage opportunity...see discussion below


Note, however, that interest rate parity will vary slightly as it will use the difference between rates.  In the above exampel, We expect the USD to depreciate by 0.66987% (2.93-2.26013) to 1.3514 USD/ Euro in the forward market (slightly different than the Fisher effect predicts).




Interest rate parity in the Forward Market


This theory states that the difference between the spot exchange rate and the forward exchange rate must be set EXACTLY equal to the difference in the interest rates between two countries. If not, then a trader could make money risk-free arbitrage.


  • Example: if the US dollar is trading with the Brazilian currency (the Real) at a R$2.0 to $1 USD spot rate, and if the forward rate was also 2:1, then a smart person could convert their money to Reais today at 2-1 ratio, and purchase a 1 year bond (denominated in Reais) at a higher interest rate, and also purchase a forward contract to guarantee that they could convert their money back to USD at a 2:1 rate. It would be a guaranteed money maker. Everyone would want to do this because there would be no risk, and you could make a higher interest rate. So, no, the bankers are smarter than this, and they don't sell a forward contract at the same rate as the spot contract. Instead, what they do is sell the forward contract at the exact rate that would eliminate all incentive to exploit this system. What rate do they use? Its easy...they look at the difference in interest rates between the two countries, and then adjust the forward contract by this exact same amount. So, if Brazil offered 12%, and the US offered 10%, then the forward contract would have to adjust for the difference, or 2%. The Brazilian currency would have to decrease in value (depreciation) by 2%. So, the forward contract would be set at exactly R$2.04 to the $1 US dollar. In this case, the forward contract exactly offsets the advantage that an investor could get by moving their money into Brazil, so there is no arbitrage opportunity. The bank MUST set the forward rate this way.


  • Another Example (of how the forward rate is set using the spot rate + interest rates of two countries): if the sport rate today is $1.40 / Euro, and the USD interest is 11.3%, and Euro interest is 6%, then the forward contract rate should be set at $1.4742 to eliminate opportunities for arbitrage. How is this rate calculated? Its easy, you first subtract 6% from 11.3% to get 5.3%. This is the amount by which the USD must depreciate. In this example, the forward exchange rate of the dollar is said to be at a Discount because it buys fewer Euros in the forward exchange rate than it does in the spot exchange rate. The Euro is said to be at a Premium.



International Fisher Effect


The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the real exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing.  this is slightly different than the domestic Fisher effect which looks at the relationship between interest and inflation. 



While it does explain how forward exchange rates are set, it has not proven to be very effective at predicting actual currency movements in the future. Contrary to the theory , currencies with high interest rates often appreciate rather than depreciate





Purchasing Power Parity, and the "Law of One Price"



The purchasing power parity (PPP) theory was developed by Gustav Cassel in 1920. It is the method of using the long-run equilibrium exchange rate of two currencies to equalize the currencies' purchasing power. It is based on the law of one price, the idea that, in an efficient market, identical goods must have only one price.


Purchasing power parity is often called absolute purchasing power parity to distinguish it from a related theory relative purchasing power parity, which predicts the relationship between the two countries' relative inflation rates and the change in the exchange rate of their currencies.


A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. These special exchange rates are often used to compare the standards of living of two or more countries. The adjustments are meant to give a better picture than comparing gross domestic products (GDP) using market exchange rates. This type of adjustment to an exchange rate is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.


Market exchange rates fluctuate widely, but many believe that PPP exchange rates reflect the long run equilibrium value. The distortions caused by using market rates are accentuated because prices of non-traded goods and services are usually lower in poorer economies. For example, a U.S. dollar exchanged and spent in the People's Republic of China will buy much more than a dollar spent in the United States.


The differences between PPP and market exchange rates can be significant. For example, the World Bank's World Development Indicators 2005 estimates that one United States dollar is equivalent to approximately 1.8 Chinese yuan by purchasing power parity in 2003. However, based on nominal exchange rates, one U.S. dollar is currently equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615.


Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.


When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.




Exchange rate (future) = Exchange rate today * (1 + Inflation foreign /  1 + inflation domestic)


XR (t+n) = [ ( 1+INFL for) / (1+INFL dom)]


But, unlike the Fisher Effect formula (which is important, and widely used)....the Purchasing Parity formula is strictly academic and is NOT used in calulating the forward exchange rate.  Understanding how it works is just to further your academic interest in the topic.  Why is it less important than the financial formula (based on interest rates)?  Because interest rate changes cause money to move immediately, but inflation is a slower change, and one that is complicated by time, and so the relationship is not as direct or as meaningful (as it might get clouded by other world events before inflation can have an effect on the FX rates).




If Mexico inflation is 6%, and US inflation is 4% (expected over the next year), and if the current spot exchange rate is M$11 / $1 USD, then the expected (in the future) spot exchange rate in one year would be = M$11 / USD  *  [(1+.06) MX /  ( 1+.04) US]  = M$11.21, which is a depreciation of the MX peso. 






Big Mac index to compare relative prices


Helps set the "starting point"...so you know whether the currency is initially over/ undervalued....then apply PPP or IFE to see expected direction.


read more in our discussion on Big Mac Index








Balance of payments model


This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance.  A nation with a trade deficit will experience reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. In the end, this could cause a balance of payments crisis.  The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.


Like PPP, the balance of payments model focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.




Asset market model



The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as economic growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services.


The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets, particularly equities.


Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates.








Asian Currency Unit - ACU COP
Euro FJD
PLN Punt






Real Effective Exchange Rate - REER

What Does It Mean Icon
What Does Real Effective Exchange Rate - REER Mean?
The weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country's currency, with each other country within the index.
Investopedia Says Icon
Investopedia explains Real Effective Exchange Rate - REER...
This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index, as adjusted for the effects of inflation. All currencies within the said index are the major currencies being traded today: U.S. dollar, Japanese yen, euro, etc.

This is also the value that an individual consumer will pay for an imported good at the consumer level. This price will include any tariffs and transactions costs associated with importing the good.







Links to GloboTrends pages 


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