Objective In this session we will learn about: Module III: Foreign Exchange Rate Determination Theories of Exchange Rate Determination, Fundamental International Parity Conditions Purchasing Power and Interest Rate Parity, Forecasting Exchange Rates - Technical Forecasting, Time Series Modelling, Fundamental Forecasting. Theories of Exchange Rate Determination
Prior to the monetary-approach emphasis
of the 1970s, it was common to emphasize international trade flows as primary determinants of exchange rates. This was due, in part, to the fact that governments maintained tight restrictions on international flows of financial capital. Theories of Exchange Rate Determination
The role of exchange rate changes in eliminating
international trade imbalances suggests that we should expect countries with current trade surpluses to have an appreciating currency, whereas countries with trade deficits should have depreciating currencies. Such exchange rate changes would lead to changes in international relative prices that would work to eliminate the trade imbalance. Theories of Exchange Rate Determination
In recent years, it has become clear that
the world does not work in the simple way just considered. For instance, with financial liberalization we have seen that the volume of international trade in financial assets now dwarfs trade in goods and services. Theories of Exchange Rate Determination
Moreover, we have seen some instances
where countries with trade surpluses have depreciating currencies, whereas countries with trade deficits have appreciating currencies. Economists have responded to such real- world events by devising several alternative views of exchange rate determination. Theories of Exchange Rate Determination
These theories place a much greater emphasis
on the role of the exchange rate as one of many prices in the worldwide market for financial assets. Modern exchange rate models emphasize financial-asset markets. Rather than the traditional view of exchange rates adjusting to equilibrate international trade in goods, the exchange rate is viewed as adjusting to equilibrate international trade in financial assets. Theories of Exchange Rate Determination
Because goods prices adjust slowly relative
to financial asset prices and financial assets are traded continuously each business day, the shift in emphasis from goods markets to asset markets has important implications. Exchange rates will change every day or even every minute as supplies of and demands for financial assets of different nations change. Theories of Exchange Rate Determination
An implication of the asset approach is
that exchange rates should be much more variable than goods prices. This seems to be an empirical fact. Exchange rate models emphasizing financial-asset markets typically assume perfect capital mobility. Theories of Exchange Rate Determination
In other words, capital flows freely between
nations as there are no significant transactions costs or capital controls to serve as barriers to investment. In such a world, covered interest arbitrage will ensure covered interest rate parity. If domestic and foreign bonds are perfect substitutes, then demanders are indifferent toward the currency of denomination of the bond as long as the expected return is the same. Purchasing Power Parity By definition the PPP states that using a unit of a currency, let us say one euro, which is the purchasing power that can purchase the same goods worldwide. The theory is based on the law of one price, which argues that should a euro price of a good be multiplied by the exchange rate ( /US$) then it will result in an equal price of the good in US dollars. Purchasing Power Parity In other words, if we assume that the exchange rate between the and US $ states at 1/1.2, then goods that cost 10 in the EU should cost US$ 12 in the United States. Otherwise, arbitrage profits will occur. However, it is finally the market that through supply and demand will force accordingly the euro and US dollar prices to the equilibrium point. Purchasing Power Parity Thus, the law of one price will be reinstated, as well as the purchase power parity between the euro and US dollar. Inflation differentials between countries will also be eliminated in terms of their effect on the prices of the goods because the PPP will adjust to equal the ratio of their price levels. Purchasing Power Parity More specifically, as stated in their book (Lumby S. & Jones C. 1999) the currency of the country with the higher rate of inflation will depreciate against the other countrys currency by approximately the inflation deferential. Purchasing Power Parity In conclusion, it can be argued that the theory, although it describes in a sufficient way the determination of the exchange rates, is not of good value, mainly because of the following two disadvantages. Firstly, not all goods are traded internationally (for example, buildings) and secondly, the transportation cost should represent a small amount of the goods worth. Purchasing Power Parity PPPs are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries. In their simplest form, PPPs are simply price relatives that show the ratio of the prices in national currencies of the same good or service in different countries. Purchasing Power Parity PPPs are also calculated for product groups and for each of the various levels of aggregation up to and including GDP. The calculation is undertaken in three stages. The first stage is at the product level, where price relatives are calculated for individual goods and services. A simple example would be a litre of Coca-Cola. Purchasing Power Parity If it costs 2.3 euros in France and 2.00$ in the United States then the PPP for Coca- Cola between France and the USA is 2.3/2.00, or 1.15. This means that for every dollar spent on a litre of Coca-Cola in the USA, 1.15 euros would have to be spent in France to obtain the same quantity and quality - or, in other words, the same volume - of Coca-Cola. Purchasing Power Parity The second stage is at the product group level, where the price relatives calculated for the products in the group are averaged to obtain unweighted PPPs for the group. Coca-cola is for example included in the product group Softdrinks and Concentrates. And the third stage is at the aggregation levels, where the PPPs for the product groups covered by the aggregation level are weighted and averaged to obtain weighted PPPs for the aggregation level up to GDP (in our example, aggregated levels are Non-alcoholic beverages, Food). Purchasing Power Parity The weights used to aggregate the PPPs in the third stage are the expenditures on the product groups as established in the national accounts. The major use of PPPs is as a first step in making inter-country comparisons in real terms of gross domestic product (GDP) and its component expenditures. Purchasing Power Parity The rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country Purchasing Power Parity: Which Weights Matter? How fast is the global economy growing? Is China contributing more to global growth than the United States? Where is the average person better off? Purchasing Power Parity These types of questions are of great interest to economists and others, and at first blush it appears reasonable to assume that each has a clear-cut answer. But, as with many things in economics, the reality is different. To answer the questions, one must compare the value of the output from different countries. Purchasing Power Parity But each country reports its data in its own currency. That means that to compare the data, each countrys statistics must be converted into a common currency. However, there are several ways to do that conversion and each can give a markedly different answer. Two different yardsticks International financial institutions produce a wide range of regional and global statistics. Purchasing Power Parity The IMF, one of these institutions, publishes many of its statisticssuch as the growth of real gross domestic product (GDP), inflation, and current account balancestwice a year in its World Economic Outlook (WEO). These statistics combine, or aggregate, the results from many countries into an average. Purchasing Power Parity The importance, or weight, of an individual countrys data in the overall result depends on the size of its economy relative to the others being compared. To derive these weights, one converts the GDP of a country in terms of its national currency into a common currency (in practice, the U.S. dollar). Purchasing Power Parity One of the two main methods of conversion uses market exchange ratesthe rate prevailing in the foreign exchange market (using either the rate at the end of the period or an average over the period). The other approach uses the purchasing power parity (PPP) exchange rate the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country. Purchasing Power Parity To understand PPP, lets take a commonly used example, the price of a hamburger. If a hamburger is selling in London for 2 and in New York for $4, this would imply a PPP exchange rate of 1 pound to 2 U.S. dollars. This PPP exchange rate may well be different from that prevailing in financial markets (so that the actual dollar cost of a hamburger in London may be either more or less than the $4 it sells for in New York). Purchasing Power Parity This type of cross-country comparison is the basis for the well-known Big Mac index, which is published by the Economist magazine and calculates PPP exchange rates based on the McDonalds sandwich that sells in nearly identical form in many countries around the world. Of course, any meaningful comparison of prices across countries must consider a wide range of goods and services. Purchasing Power Parity This is not an easy task, because of the amount of data that must be collected and the complexities in the comparison process. To facilitate price comparisons across countries, the International Comparisons Program (ICP) was established by the United Nations and the University of Pennsylvania in 1968. PPPs generated by the ICP are based on a global survey of prices. Purchasing Power Parity For the 200306 round, each of the participating countries (about 147) provided national average prices for 1,000 closely specified products. PPP versus market rates So which method is better? The appropriate way to aggregate economic data across countries depends on the issue being considered. Interest Rate Parity Interest Rate Parity (IPR) theory is used to analyze the relationship between at the spot rate and a corresponding forward (future) rate of currencies. The IPR theory states interest rate differentials between two different currencies will be reflected in the premium or discount for the forward exchange rate on the foreign currency if there is no arbitrage - the activity of buying shares or currency in one financial market and selling it at a profit in another. Interest Rate Parity The theory further states size of the forward premium or discount on a foreign currency should be equal to the interest rate differentials between the countries in comparison. 1. Covered Interest Rate Parity (CIRP) Covered Interest Rate theory states that exchange rate forward premiums (discounts) offset interest rate differentials between two sovereigns. Interest Rate Parity In another words, covered interest rate theory holds that interest rate differentials between two countries are offset by the spot/forward currency premiums as otherwise investors could earn a pure arbitrage profit. Covered Interest Rate Examples Assume Google Inc., the U.S. based multi- national company, needs to pay it's European employees in Euro in a month's time. Interest Rate Parity Google Inc. can achieve this in several ways viz: Buy Euro forward 30 days to lock in the exchange rate. Then Google can invest in dollars for 30 days until it must convert dollars to Euro in a month. This is called covering because now Google Inc. has no exchange rate fluctuation risk. Interest Rate Parity Convert dollars to Euro today at spot exchange rate. Invest Euro in a European bond (in Euro) for 30 days (equivalently loan out Euro for 30 days) then pay it's obligation in Euro at the end of the month. Under this model Google Inc. is sure of the interest rate that it will earn, so it may convert fewer dollars to Euro today as it's Euro will grow via interest earned. Interest Rate Parity This is also called covering because by converting dollars to Euro at the spot, the risk of exchange rate fluctuation is eliminated. 2. Uncovered Interest Rate Parity (UIP) Uncovered Interest Rate theory states that expected appreciation (depreciation) of a currency is offset by lower (higher) interest. Interest Rate Parity Google Inc. can also invest the money in dollars today and change it for Euro at the end of the month. This method is uncovered because the exchange rate risks persist in this transaction. Covered Interest Rate Vs. Uncovered Interest Rate Interest Rate Parity Recent empirical research has identified that uncovered interest rate parity does not hold, although violations are not as large as previously thought and seems to be currency rather than time horizon dependent. In contrast, covered interest rate parity is well established in recent decades amongst the OECD economies for short-term instruments. Interest Rate Parity Any apparent deviations are credited to transaction costs. Implications of Interest Rate Parity Theory If IRP theory holds then arbitrage in not possible. No matter whether an investor invests in domestic country or foreign country, the rate of return will be the same as if an investor invested in the home country when measured in domestic currency. Interest Rate Parity If domestic interest rates are less than foreign interest rates, foreign currency must trade at a forward discount to offset any benefit of higher interest rates in foreign country to prevent arbitrage. If foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset the interest rate advantage of foreign country, arbitrage opportunity exists for domestic investors. Interest Rate Parity So domestic investors can benefit by investing in the foreign market. If domestic interest rates are more than foreign interest rates, foreign currency must trade at a forward premium to offset any benefit of higher interest rates in domestic country to prevent arbitrage. Interest Rate Parity If foreign currency does not trade at a forward premium or if the forward premium is not large enough to offset the interest rate advantage of domestic country, arbitrage opportunity exists for foreign investors. So foreign investors can benefit by investing in the domestic market. Interest Rate Parity Limitations of Interest Rate Parity Model In recent years the interest rate parity model has shown little proof of working. In many cases, countries with higher interest rates often experience it's currency appreciate due to higher demands and higher yields and has nothing to do with risk-less arbitrage. Interest Rate Parity Another difference between the Monetary Approach to Balance of Payment (MBOP) and the IRP is how they define the expected exchange rate. In the MBOP, the expected exchange rate is included in the parity equation. The expected exchange rate reflects investors expectations regarding the exchange rate some time from now. Interest Rate Parity In fact, investors adjust their exchange rate expectations upward or downward. However, the MBOP does not explicitly provide any tools that can quantify the expected exchange rate. The IRP quantifies the expected exchange rate using forward contracts. Forward contracts are an example of foreign exchange derivatives. Interest Rate Parity You can think of foreign exchange derivatives as financial contracts where you lock in a specific exchange rate today for a future transaction in currencies (buying or selling of currencies). A forward contract is an example of a foreign exchange derivative. It allows you to trade one currency for another at some date in the future at an exchange rate specified today. Interest Rate Parity Typically, you get a forward contract from a bank that is engaged in foreign exchange transactions. A forward contract includes the forward rate (the exchange rate on the forward contract), the amount of currency to be bought or sold, and the transaction date. Interest Rate Parity Forward contracts are binding, in the sense that there is an obligation to buy or sell currency at the agreed price for the agreed quantity on the agreed transaction day. The forward rate may be a good approximation of the expected exchange rate in the bracket of the parity equation in the MBOP. Interest Rate Parity You might expect that a bank considers the current and expected values of the relevant variables for the exchange rate in both countries and quote a forward rate to you. Difference between MBOP and IRP First, when the MBOP talks about the interest rate differential, it means the difference in two countries real interest rates. Interest Rate Parity The IRP is also interested in the difference between interest rates as a predictor for changes in the exchange rate, but the IRP thinks in terms of nominal interest rates. Second, whereas the MBOP uses the concept of an expected exchange rate, it doesnt specify how you can measure it. The IRP, on the other hand, uses the forward rate as indicated on a forward contract to get a numerical estimate for the expected change in the exchange rate. Forecasting Exchange Rates There are numerous methods of forecasting exchange rates, likely because none of them have been shown to be superior to any other. This speaks to the difficulty of generating a quality forecast. Purchasing Power Parity (PPP) The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. Forecasting Exchange Rates The PPP forecasting approach is based off of the theoretical Law of One Price, which states that identical goods in different countries should have identical prices. For example, this law argues that a pencil in Canada should be the same price as a pencil in the U.S. after taking into account the exchange rate and excluding transaction and shipping costs. Forecasting Exchange Rates Relative Economic Strength Approach As the name may suggest, the relative economic strength approach looks at the strength of economic growth in different countries in order to forecast the direction of exchange rates. The rationale behind this approach is based on the idea that a strong economic environment and potentially high growth is more likely to attract investments from foreign investors. Forecasting Exchange Rates And, in order to purchase investments in the desired country, an investor would have to purchase the country's currency - creating increased demand that should cause the currency to appreciate. This approach doesn't just look at the relative economic strength between countries. It takes a more general view and looks at all investment flows. Forecasting Exchange Rates For instance, another factor that can draw investors to a certain country is interest rates. High interest rates will attract investors looking for the highest yield on their investments, causing demand for the currency to increase, which again would result in an appreciation of the currency. Conversely, low interest rates can also sometimes induce investors to avoid investing in a particular country or even borrow that country's currency at low interest rates to fund other investments. Forecasting Exchange Rates Many investors did this with the Japanese yen when the interest rates in Japan were at extreme lows. This strategy is commonly known as the carry-trade. Unlike the PPP approach, the relative economic strength approach doesn't forecast what the exchange rate should be. Forecasting Exchange Rates Rather, this approach gives the investor a general sense of whether a currency is going to appreciate or depreciate and an overall feel for the strength of the movement. This approach is typically used in combination with other forecasting methods to develop a more complete forecast. Forecasting Exchange Rates Econometric Models Another common method used to forecast exchange rates involves gathering factors that you believe affect the movement of a certain currency and creating a model that relates these factors to the exchange rate. The factors used in econometric models are normally based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate. Forecasting Exchange Rates As an example, suppose that a forecaster for a Canadian company has been tasked with forecasting the USD/CAD exchange rate over the next year. He believes an econometric model would be a good method to use and has researched factors he thinks affect the exchange rate. From his research and analysis, he concludes the factors that are most influential are: the interest rate differential between the U.S. and Canada (INT), the difference in GDP growth rates (GDP), and income growth rate (IGR) differences between the two countries. Forecasting Exchange Rates The econometric model he comes up with is shown as: USD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR) We won't go into the details of how the model is constructed, but after the model is made, the variables INT, GDP and IGR can be plugged into the model to generate a forecast. The coefficients a, b and c will determine how much a certain factor affects the exchange rate and direction of the effect (whether it is positive or negative). Technical Forecasting International transactions are usually settled in the near future. Exchange rate forecasts are necessary to evaluate the foreign denominated cash flows involved in international transactions. Thus, exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment. Technical Forecasting A forecast represents an expectation about a future value or values of a variable. The expectation is constructed using an information set selected by the forecaster. Based on the information set used by the forecaster, there are two pure approaches to forecasting foreign exchange rates: (1) The fundamental approach. (2) The technical approach. Technical Forecasting Technical analysis in exchange rates is a method which is used to predict the future trends of exchange rates in forex market by analyzing the past market data, mainly the data related to volume and price. Technical analysis in forex exchange rates forecasting focuses on recognizing the rate patterns and trends and tries to explore those trends. Technical Forecasting There are various tools used by the technicians, however, the main tools is the study of price charts. In exchange rate forecasting with technical analysis, the experts especially look for repeated patterns like double top reversal patterns, candlesticks, head and shoulders patterns or study indicators like moving averages. Technical Forecasting The indicators, which are mathematical transformations of historical market data relating to volume and price, are used extensively for technical analysis in exchange rates. The investors in forex market consider technical analysis for exchange rate forecasting as one of the key tools. Technical Forecasting As we know that technical analysis in exchange rates forecasting gives us a clear picture of prices movement in future by taking into account the historical market prices analysis and it is made up of mathematical equations along with other technical applied towards market prices. One should have a through knowledge of forex technical analysis techniques to get fruitful results. Technical Forecasting With technical analysis in forex exchange rates, one should always remember that theoretical knowledge added to the thoughtful strategy gives the key to good results and positive trading. You shouldn't ever use the methods you understand not clearly. There is always a choice from a number of methods offered, so you can use the one you are good at and invest adequately for successful Forex trading. Technical Forecasting The forex currency market is essentially trend-following over a short term period. A large majority comprises of speculative market participants and this is the reason why there are currency transactions happening which have no underlying investment transaction behind them. Technical Forecasting The forex trading market participants have to trade off something whether or not there has been any change in macroeconomic fundamentals. The traditional forecasting methods are not that efficient to predict short term market moves; therefore some other analytical method required which can help in getting better results. Technical Forecasting The patterns created by supply and demand in exchange rate create price patterns, which can be used for technical analysis in exchange rates. Technical analysis is used by the investors alone or with fundamental analysis exclusively. There are various methods along with technical analysis which can be used in forecasting, but thing is that they all rely on price movements of the past. Time Series Modelling Exchange rate is the currency rate of one country expressed in terms of the currency of another country. In the modern world, exchange rates of the most successful countries are tend to be floating. This system is set by the foreign exchange market over supply and demand for that particular currency in relation to the other currencies. Time Series Modelling In addition, the exchange rate is guided by significant impact of the activities of central banks and other financial institutions. It seem to be very difficult to analyze how the foreign exchange rate changes, and probably even harder to forecast them. There are lot of works done on time series based prediction modelling of foreign currency rates in literature. Time Series Modelling Many authors created and tested the Autoregressive Integrated Moving Average (ARIMA) model to forecast exchange rates. Monthly or daily exchange rates were used as the variable output in these reports. These studies outlined that the ARIMA model is comparatively accurate model to forecast the exchange rate. Time Series Modelling Akincilar et al. studied the exchange rate forecasting of US dollar, euro and Great Britain pound with respect to the Turkish lira. Several methods were performed for forecasting and then compared with the ARIMA model. The performance of the models was estimated via mean absolute percentage error (MAPE), root mean square errors (RMSE) and mean square error (MAE). Time Series Modelling Weisang et al. further developed a detailed ARIMA modelling in the form of a case study using macroeconomic indicators to model the USD/EUR exchange rate. They developed a linear relationship for the monthly USD/EUR exchange rate over the period from January 1994 to October 2007. Time Series Modelling Besides this, Box-Jenkins approach is applied successfully in many areas such as tourism demand, energy and many others. Box and Jenkins ARIMA technique has been extensively used as a standard for time series forecasting and for evaluation of the new modelling approaches in the last twenty five years, and probably it dominates the time series forecasting. Time Series Modelling Box-Jenkins paid special attention to the selecting the model and its evaluation. The methodology for constructing ARIMA model for the investigated time series includes the following main steps: 1. Identification of test patterns; 2. Estimation of the model parameters and identifying the adequacy of the model; Time Series Modelling 3. The use of models to predict. Forecasting exchange rate appears to be a very attracting topic in international finance. Time series modeling is a dynamic research area which has attracted attentions of researchers community over last few decades. Time Series Modelling The main aim of time series modeling is to carefully collect and rigorously study the past observations of a time series to develop an appropriate model which describes the inherent structure of the series. This model is then used to generate future values for the series, i.e. to make forecasts. Time Series Modelling Time series forecasting thus can be termed as the act of predicting the future by understanding the past. Due to the indispensable importance of time series forecasting in numerous practical fields such as business, economics, finance, science and engineering, etc., proper care should be taken to fit an adequate model to the underlying time series. Fundamental Forecasting Fundamental analysis is the study of economic factors that influence foreign exchange rates in the hope of trying to forecast future rates. Fundamental analysis in forex attempts to predict currency moves by studying interest rates, government policies, business cycles, and economic growth in the 2 countries where the currencies are being compared. Fundamental Forecasting Both countries must be compared because the foreign exchange rate is determined by the relative value of the currencies in the 2 countries, so if economic factors increase the strength of the currency in 1 country, that will have the same effect on the exchange rate if economic factors in the other country weakens its currency. Fundamental Forecasting So any change in exchange rates can result either because a currency strengthened or the other weakened, or both, and vice versa. In contrast, technical analysis involves the study of volume and price levels, and chart patterns of currencies to forecast future currency moves, which is predicated on the assumption that certain patterns in the charts can forecast, more often than not, exchange rates. Fundamental Forecasting It is fundamental analysis, however, that examines the economic factors that ultimately determines currency rates, since it is based on cause and effect. Since any forex transaction involves the exchange of 1 currency for another, fundamental analysis must, by necessity, take into account the supply and demand of each currency with respect to the other, which determines the exchange rate. Fundamental Forecasting Hence, proponents of fundamental analysis try to ascertain supply and demand by studying various economic indicators and other economic data which will affect the supply and demand of each currency with respect to the other. The most important economic factors of the 2 currencies being compared are inflation rates, interest rates, and investment opportunities. Fundamental Forecasting The 2 factors that governments have the most influence over are inflation and interest rates. Inflation is generally caused when the government increases the money supply faster than the economy is growing. If the inflation rate is higher in one country then in another, then the relative value of its currency will decline. Fundamental Forecasting Indeed, some countries print so much money that the currency becomes worthless as money. For instance, people in Zimbabwe would sometimes use Zim dollars as toilet paper. Because money has such an important function in all societies, people will often find substitutes when the domestic currency becomes worthless even using the currency of another country, in what is known as dollarization. Fundamental Forecasting While inflation lowers the value of currency, higher interest rates increase it, since higher interest rates draws capital from around the world as money seeks a higher rate of return, thereby, increasing the demand for the currency as foreigners convert their domestic currency into the investment currency. Fundamental Forecasting One such example is the so-called carry trade, which involves borrowing currency from a country with low interest rates to invest it in a country with higher rates, such as when investors borrow Japanese yen at low interest rates to invest in New Zealand and Australia, which usually have the highest interest rates. Fundamental Forecasting Investment opportunities have the same effect as higher interest rates; indeed, higher interest rates are simply another form of investment opportunity. However, other than interest rates, governments do not have as much control over investment opportunities, although they exert influence by their stewardship of their economies. Another major factor is the size of the economies. Fundamental Forecasting If an economy is underdeveloped, compared with the rest of the world, then it will have a much greater potential for growth relative to a developed economy, since foreign companies will seek to sell their goods and services in a market that is far from being saturated. Such is the case today, as companies around the world strive to have a presence in China and India, where the potential for sales growth is much greater than in, say, the United States or Europe. Fundamental Forecasting Investment risks have the opposite effect of higher interest rates and greater investment opportunities, in that higher investment risks will lower the demand for the investments. In foreign exchange, after inflation and interest rate risk, the main investment risks in foreign countries, especially smaller, volatile countries, is political risk. Fundamental Forecasting Political risk often takes the form of market volatility, when it becomes difficult to forecast interest rates or other economic factors that may affect businesses. High taxes may reduce investment returns and the country may institute capital controls, restricting the flow of capital either into the country or out of the country or both. Fundamental Forecasting Any type of capital control will reduce the demand for the currency, since investors usually don't like to lose control of their capital. Since inflation, interest rates, and returns on investments are the most important factors in determining exchange rates, foreign exchange traders frequently scan publications mostly issued by central banks, since they usually determine interest rates and control the supply of money for any indication on how these factors will change. Fundamental Forecasting Forex traders generally have expectations about what a country will do, so any surprises from what was expected may change exchange rates dramatically. Hence, the key to forecasting exchange rate moves using fundamental analysis requires that the trader know the publication schedule of major reports for each relevant country and understand their significance. Fundamental Forecasting Fundamental analysis - Consists of reviewing the economic and political reasons behind currency moves. Often involves interpreting the micro and macro economic indicators for the currency's nation in order to determine the relative value of the currency versus another currency. Fundamental analysis can be better for forecasting longer term exchange rate moves. Fundamental Forecasting Fundamental analysis in the forex market typically involves taking into account basic economic and political factors for one country relative to another. These factors might include the following: Measures of overall economic strength like growth and employment rates Interest rates and investment yields Trade and current account balances Fundamental Forecasting Political stability Fundamental forecasts for exchange rates are typically most useful for longer term time frames and not so much for short term trading. Nevertheless, some fundamental trading strategies have been developed that operate during the volatile period that often immediately follows important economic data releases. Fundamental Forecasting Some traders prefer technical analysis and take issue with fundamental analysis on the basis that: Its information is largely already priced into the market It is time consuming and complicated to perform It often requires an economics background It does not give objective trading signals Fundamental Forecasting Economic indicators are statistics, published periodically, that measure various factors of the economy, many of which affect, or are affected, by the supply and demand of the domestic currency. Moreover, central banks rely on economic indicators to formulate monetary policy, which can have a significant effect on foreign exchange rates. Recap In this session we learnt about: Module III: Foreign Exchange Rate Determination Theories of Exchange Rate Determination, Fundamental International Parity Conditions Purchasing Power and Interest Rate Parity, Forecasting Exchange Rates - Technical Forecasting, Time Series Modelling, Fundamental Forecasting. 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