What you need to know about exchange rate forecasting
There is no reliable method available to forecast exchange rates. Paul Krugman and Maurice Obstfeld write in their book "International Economics: Theory and Policy" (New York, HarperCollins:1994): If exchange rates are asset prices that respond immediately to changes in expectations and interest rates, they should have properties similar to those of other asset prices, for example, stock prices. Like stock prices, exchange rates should respond strongly to "news," that is, unexpected economic and political events; and, like stock prices, they therefore should be very hard to forecast. In a study by Richard M. Levich ("Evaluating the Performance of the Forecasters", in: Donald R. Lessard, ed., "International Financial Management", New York: John Wiley:1985, pp. 218-233) in which he surveyed the track record of a dozen exchange rate forecasting companies through 1982 he found little evidence that professional forecaster do systematically better than an individual who, for example, uses the three month forward rate. That does not imply that forward rates are good predictors. In fact, they usually do not predict exchange rate movements very well.
How are exchange rates determined?
Long term movements are driven by fundamental forces, such as purchasing power parity and cross-country differences in inflation. In the short run, exchange rate movements are driven by news and events, and in particular changes in interest rates, and changes in expectations about fundamental macro-economic factors. For excellent surveys of exchange rate theory refer to:
- Richard Baillie and Patrick C. McMahon: The foreign exchange market: theory and econometric evidence. Cambridge University Press, New York, 1989.
- Lawrence S. Copeland: Exchange Rates and International Finance. Addison-Wesley, Reading/Mass., 1990.
- Christian Dunis and Michael Feeny (editors): Exchange Rate Forecasting. Woodhead-Faulkner, New York, 1989.
- Peter Isard: Exchange Rate Economics. Cambridge University Press, Cambridge, 1995.
- Ronald MacDonald and Mark P. Taylor: Exchange Rate Economics: A Survey. IMF Staff Papers, 39(1), 1-57.
If exchange rate forecasts are not reliable, why bother?
As pointed out above, economists do not possess reliable methods of forecasting exchange rates over short time horizons such as days or weeks. Fundamental economic forces (such as purchasing power parity and balance-of-payment disequilibrium) usually take much longer, often several years, to have an effect on exchange rates. Nevertheless, the business community has to form expectations about the short-term trends of exchange rates. Because these expectations are formed by market sentiment, trends can be extrapolated. At the same time, market sentiments can change as financial news change the outlook on a country's economic prospects. The PACIFIC Exchange Rate Service provides three sets of exchange rate trends using different "technical" trending techniques for 15-day and 30-day intervals, and ARIMA regression forecasts for a 4-week interval. Trends based on economic fundamentals (usually for quarterly or annual projections) are usually obtained through large structural computational models. The PACIFIC trends are intended to reveal market trends, not fundamental determinants. Users of the trend charts are advised to read them with considerable caution.
How are the trend projections calculated?
The 120-day corridor analysis and 30-day trend projection
is based on technical analysis of the linear trend and
a surrounding band that maximizes a score function to make
the corridor narrow but long. The corresponding channel
analysis and 15-day trend projection uses multiple
channel segments that are at least 15 days long
and minimize an objective function that penalizes breaks.
Note that with any technical analysis, different parameter
assumptions yield different outcomes.
An inherent limitation of this approach
is that trend projections cannot predict trend reversals.
The 4-week forecasts employ auto-regressive integrated moving-average ARIMA(p,q,r) regressions with degrees (p,q,r) chosen automatically by the R forecast package, based on the logarithmic exchange rates of the last 120 days. The expanding ribbon shows the 80-percent confidence interval of the ARIMA forecast. The slight choppiness of the ribbon is an artifact of the forecasting method for workdays (Monday through Friday) while excluding Saturdays and Sundays. This feature is intentional.
All trend projections were coded in the R language by the author. The current version of the software was developed in January 2023.
I make no warranties, express or implied, that the exchange rate trend projections/forecasts are accurate, useful, consistent with any economic theory, reliable, or consistent with any particular standard of merchantability, or that they will meet your requirements for any particular application. These trend projections/forecasts should not be relied upon for carrying out any currency transactions which could result in injury to a person or loss of property. If you do use the forecasts in such a manner, it is at your own risk. I disclaim all liability for direct or consequential damages resulting from your use of these trend projections/forecasts.