There are a number of different ways that you can forecast the foreign currency exchange changes. There are 4 different ways that you can do this that you should know about. You should consider what these methods are and how you can use them in your trading.
The Purchase Power Parity of the Foreign Currency Exchange
PPP or purchasing power parity is the most commonly used method because it is taught to economists and can easily be found in economic textbooks. This method is based off the Law of One Price theory. This theory states that products in different countries may have the same price. This means that if you have a pen in Australia it should have the same price as a pen in New Zealand.
Using this theory as a base traders looking at PPP, approach currency need to consider inflation. PPA forecasts that the forex rate changes to offset the inflation differences. If the prices in one country are thought to increase by 6% and another country by 3% the inflation differential is 1%. This means that the PPP of the first country would need to be depreciated by 1% to keep them even.
There are many applications which use this theory to forecast forex. One of the most common is called the Big Mac Index. This rather light hearted index measures currency based on the prices on the Big Mac in different countries.
The Relative Economic Strength Approach
The relative economic strength approach does exactly as it says: looks at the strength of economic growth in different countries. The basis of this method is that the stronger the economic growth the more attractive the country is to investors. This means that the demand for the currency will increase when the number of investors increases.
When you use this approach you will not only look at the relative economic strengths of countries. You will also be looking at all investments and the general view of the economy. One of the other factors that you need to consider is the interest rate. This rate has a major impact on the attractiveness of a country to investors.
The Econometric Models
Another commonly used method to forecast currency changes is to gather economic data that will affect the forex market. The use of this data is known as an econometric model and is based on economic theories, but they can vary depending on the country and the information.
With this model you will be looking at historical and coming information and creating a model. This method, while commonly used, is actually one of the more complex and time consuming. However, one you have created the model you simply need to insert the data to get quick forecasts.
The Time Series Model
The time series model is the last method that you should look at. This method is actually purely technical while the others are more fundamental in nature. There is also no basis in economic theory with this method. One of the most popular time series approaches is the ARMA or autoregressive moving average. This uses that theory that previous patterns and movements predict what will happen in the future.
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