Exchange Rate Forecasting

Abstract

In the previous chapter, we discussed theories of exchange rate determination and we looked at some of the macroeconomic variables (fundamentals) that influence and are influenced by the exchange rate. We can envision a “true” model of the two economies (domestic and foreign) that include all of these variables, incorporate full information, and expectations and in the context of economic optimization and random events generate the time path of foreign exchange rate between two currencies. Forecasting can be thought of as the formal process of generating expectations by using economic theory, mathematics, statistics, and econometric analysis. When expectations for future economic variables are derived, we have an implicit forecast of the variable in question, the exchange rate. The rational expectations theory says that people form expectations of future values of the exchange rate and other variables in the same way that the “true” model of the economy generates these variables. Forecasting is very common and necessary in our times. People take forecasting into consideration when they make economic decisions. These decisions then influence the direction in which the economy will move. Cash flows of all international transactions are affected by the expected value of the exchange rates; therefore, forecasting exchange rate movements is very important for businesses, investors, and policy makers.