Traders have a choice of several different methods of forecasting the foreign exchange rate. It is not possible to say that one method is superior to another as it is extremely difficult to predict the forex rates.
Time Series Model
This is a technical method of analysis and is not based on an economic theory. One of the popular versions of a time series model is the Autoregressive Moving Average Process. This method uses a basis of forecasting future price behaviour and patterns by observing past price behaviour and patterns. You require a time series of data which you can input into a software system to undertake estimation and create a model for you to do suitable predictions.
Econometric Rates Model
This is an extremely popular method of predicting. It involves the collection of factors you believe are responsible for a currency’s movement and using those factors to develop a model that offers you a prediction. The factors you use are normally based on economic theory, but you could add all the variables you believe would have an impact on the foreign exchange rate.
An example of this method is an analyst at an Australian firm is given the task to calculate a prediction of the USD/AUD currency pair rate over the next year. He decides on an econometric model and has done adequate research on the other factors he believes could have an impact on the rate. Based on his research and analysis, he arrives at the conclusion that factors such as the income growth rate variance, the interest rate variance and the GDP growth rates between the two countries will have an impact on the foreign exchange rate.
To arrive at a suitable model, he would have to add the variable factors once he has constructed the model. As is evident, this is an extremely complex and time consuming method of calculation. The main advantage is that once the model has been researched and developed, keeping it up to date is a simple matter of adding the variables to obtain a quick rate forecast.
Relative Economic Strength Model to Forecast the Foreign Exchange Rate
This method makes use of the strength of the economic growth in different countries to forecast the possible direction of the forex rates. The basis of this method is that a stable and strong economic climate with high growth levels will attract foreign investment. To purchase any form of investment in a country, it is necessary to purchase that country’s domestic currency. This causes the demand for the currency to increase which ultimately causes the currency value to rise.
This model is not only used to view the economic strength of the countries, but it also looks at a much broader outlook in the flow of investments. Interest rates will also draw foreign investment to a country. Countries that have high interest rates normally attract investors who are searching for a better return on their investments. This investment causes an increase in the demand for the currency which eventually increases the value of the currency.
This method is not able to predict the value of the currency. It merely provides the trader with a basic idea as to whether there will be an increase or decrease. It also indicates the strength of the movement.