Name: Nguyen Thuy Tien (Tien Nguyen)

Subject: International economics – ECO 322

Short paper
Question: Research the many different methods for forecasting exchange rates and, in a short
paper, present the three methods you think are most effective. (There are many more than were
mentioned in the lecture, so don't limit yourself to those). Explain these methods and offer real-
world examples where they would function effectively in exchange rate prediction.

There are various approaches for forecasting currency exchange rates. In this study, however, I
will only include three exchange rates that I believe are the most effective: Purchasing Power
Parity (PPP), relative economic strength, and ARIMA time series models.

Purchasing power parity is not a new concept; it is one of the most often used approaches for
forecasting exchange rates. It is even deemed popular as a result of its inclusion in most
economic textbooks. The PPP forecasting technique is based on the theoretical concept of one
price, which asserts that equivalent items should have comparable pricing in various nations
(Nguyen, 2011).
This implies that once the currencies have been exchanged, commodities in each country will
cost the same. According to the PPP theory, if a Coca-Cola costs 100p in the UK and $1.50 in
the US, the GBP/USD exchange rate should equal 1.50 (the US price divided by the UK price).
However, if you check the GBP/USD market exchange rate, you'll notice that it's closer to 1.25.
The disparity arises because the buying power of various currencies varies. A currency, like any
other asset, has a real value and a notional value, which financial markets trade at. The purpose
of the PPP measurement is to make comparisons between two currencies more meaningful by
compensating for variations in buying power across countries.
Global organizations such as the World Bank, United Nations, International Monetary Fund, and
European Union depend largely on PPP indicators (IG, 2019).

The relative economic strength approach, as the name implies, considers the strength of
economic growth in various nations in order to anticipate the direction of exchange rates. This
strategy is based on the assumption that a strong economic environment with the potential for
rapid growth is more likely to attract foreign investment. 

This method considers more than simply the relative economic strength between countries. It
gives a broader perspective and examines all investment flows. Interest rates, for example, are
another aspect that might entice investors to a certain nation. High-interest rates will attract
investors seeking the maximum yield on their investments, increasing demand for the currency,
and resulting in currency appreciation.
Low-interest rates, on the other hand, will discourage investors from investing in a certain
nation. Investors may even borrow the low-cost currency of that country to fund other projects.
This was the situation when interest rates on the Japanese yen were extraordinarily low. This is
known as the carry-trade approach (IG, 2019).

Autoregressive Integrated Moving Average (ARIMA) computations are used in many statistical
models these days. These models are often data-driven and do not necessarily correspond to any
particular economic theory. Instead, they investigate historical factors in order to distinguish
seemingly unrelated variations from continuous and important trends. They can also precisely
track seasonal impacts such as tourism. Extrapolation allows the models to make longer-term
projections to some extent (OFX, 2022). It’s used when a metric is recorded in regular intervals,
from fractions of a second to daily, weekly or monthly periods (Master's in Data Science, 2022).

References:

 Exchange rate forecasting: Strategies for success. (2022, June 30). Retrieved from

https://www.ofx.com/en-au/forex-news/forecasting/

 Master's in Data Science. (2022, July 14). ARIMA modeling. Retrieved from

https://www.mastersindatascience.org/learning/statistics-data-science/what-is-arima-

modeling/

 Nguyen, J. (2011, April 4). Learn 3 common ways to forecast currency exchange rates.

Retrieved from https://www.investopedia.com/articles/forex/11/4-ways-to-forecast-

exchange-rates.asp

 What is purchasing power parity (PPP)? (2019, November 6). Retrieved from

https://www.ig.com/en/trading-strategies/what-is-purchasing-power-parity--ppp---

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