Forecasting Exchange Rates | cfa level 3 notes
LOS-discuss major approaches to forecasting exchange rates
Major approaches to forecasting exchange rates include:
1.Focus on Goods and Services, Trade, and the Current Account:
-Trade Flows: While trade flows have a limited direct impact on exchange rate movements, large imbalances may indicate an emerging crisis.
-Purchasing Power Parity (PPP): PPP suggests that exchange rates should adjust to equalize the prices of goods and services across currencies. However, PPP is a better predictor of long-term currency movements.
-Competitiveness and Sustainability of the Current Account: The current account balance, influenced by saving and investment differentials, can impact exchange rates. Sustainable imbalances and their sources play a crucial role in determining the influence on currencies.
2.Focus on Capital Flows:
-Implications of Capital Mobility: Capital seeks the highest risk-adjusted expected return, and exchange rates adjust to equalize these expected returns. The exchange rate reflects differences in interest rates, term premiums, credit premiums, equity premiums, and liquidity premiums.
-Uncovered Interest Rate Parity (UIP) and Hot Money Flows: UIP suggests that the expected change in exchange rates equals the nominal interest rate differential. However, carry trades (borrowing in low-rate currencies and lending in high-rate currencies) tend to be profitable, indicating deviations from UIP.
-Portfolio Balance, Portfolio Composition, and Sustainability Issues: Capital flows and strategic allocations based on economic growth rates and current account balances influence exchange rates. Wealth transfers and the composition of currency portfolios also impact currency valuation.
It’s important to note that these approaches are complementary rather than mutually exclusive, and they provide different insights into the complex nature of exchange rate forecasting.
18 Jul 2023 - Original by toptradeready.com