The term “foreign exchange rate forecast” is one heard often in the world of investing and finance, but what exactly does it mean and how is it calculated? Here we will provide a working definition of foreign exchange rate forecasts, along with some of the approaches which are applied to this formula and the models most often used by forecasters.

Foreign Exchange Rate Forecasts Defined

Foreign exchange rate forecasts are, in essence, predictions of how well a particular currency will hold its value compared to the currency of another nation over a period of time. The forecasted exchange rate of the Canadian dollar, for example, is typically measured against the US dollar. Foreign exchange rate forecasts are by no means an exact science, as evidenced by the many different approaches that are used to arrive at these forecasts, each with its own limitations.

Foreign Exchange Rate Forecasts: Two Approaches

While there are several different approaches employed by economists to arrive at foreign exchange rate forecasts, the following two methods are used most frequently:

• Technical Forecasting. The technical analysis approach to forecasting relies exclusively on the behavior of investors. With this approach, computer charts are consulted to predict which direction the exchange rate will follow based on investment patterns, positioning surveys and moving averages.
• Fundamental Approach to Forecasting. In fundamental forecasting, several factors are considered which may affect long-term cycles of a particular currency. These factors include inflation, GDP and the balance of trade, all of which are believed to be reliable predictors of a currency’s projected worth.

Foreign Exchange Rate Forecast: A Look at the Formula Models

Foreign exchange rate forecasts are predicted using a variety of forecast models. These include:

• Uncovered Interest Rate Parity Model. The UIP model measures the average return on investments of the two currencies being compared, and then averages those statistics to forecast the future exchange rate.
• Purchasing Power Parity Model. The PPP model forecasts the foreign exchange rate based on the price level changes of the currency in each country.

One final model is the Random Walk Model, believed by many experts to be just as reliable as the two mentioned above. In this model, forecasters merely assume—because that’s all they can do—that the current exchange rate will remain unchanged. According to this model, any future changes that may affect the future exchange rate are purely random, and thus unpredictable. Oliver totally disagrees with the random walk model and strongly believes that his forecast of dramatic foreign exchange rate dislocations due to the coming financial crisis in the U.S. is completely predictable, and absolutely not random.