Market participants who use foreign exchange derivatives tend to take positions
ID: 2655222 • Letter: M
Question
Market participants who use foreign exchange derivatives tend to take positions based on their expectations of future exchange rates. Portfolio managers of financial institutions may take positions in foreign exchange derivatives to hedge their exposure if they anticipate a decline in the value of the currency denominating their stocks. Speculators may take positions in foreign exchange derivatives to benefit from the expectation that specific currencies will strengthen. There are various techniques for forecasting, but no specific technique stands out because most have had limited success in forecasting future exchange rates.
As the value of a currency adjusts to changes in demand and supply conditions, it moves toward equilibrium. In equilibrium, there is no excess or deficiency of that currency. Thus, the initial task is to develop a forecast of specific exchange rates.
Discuss the following:
Discuss the four exchange rates forecasting methods and which you believe is the best to use and why.
Of the factors that affect exchange rates, in your opinion which one has the biggest impact? Why?
Explanation / Answer
Answer:
Following are four exchange rates forecasting methods:
1. Purchasing Power Parity (PPP):
This method of exchange rate forecasting approach is based on the Law of One Price. It assumes that same goods in different countries should have same prices.
PPP method forecasts that the exchange rate will change w.r.t. changes due to inflation. For example, if expected inflation rate in U.S. is 3% and expected inflation in India is1%. Hence inflation differential between the two countries is = 3% -1% = 2%
Now suppose the current exchange rate is $1 = Rs. 60
Hence as per PPP the expected exchange rate shall be = $1 = Rs 60 /(1.02) = Rs. 58.82
2. Relative Economic Strength Method:
This Method considers the strength of economic growth in different countries to forecast the exchange rates. This method is based on the theme that a strong economic environment shall attract investments from foreign investors. And this shall increase the demand for the currency and hence the currency shall gain over foreign currencies.
3. Econometric Models
4. Time Series Model:
This methods forecast the exchange rates on the basis of the trend of time series.
The best method to forecast the exchange rate is PPP as it consider the inflation as well.
There are various factors that affect the exchange rate like :
Interest rate ,
Economic conditions
Inflation rate
The most important factor is interest rate as it directly affects the money market that results in change in the foreign exchange rates.