Techniques of Exchange Rate Forecasting

There are several techniques available for forecasting exchange rates. They can be categorized into four general groups- Technical Forecasting, Fundamental Forecasting, Market-based Forecasting, and Mixed Forecasting.

Technical Forecasting: It involves the use of historical data to predict future value For example, time series models. This idea behind this technique is a well known phenomenon that movements in the markets are 90% physiological and 10% logical which states that investors sentiments are behind the exchange rate determination. Speculators have to work out the models which helps in predicting day-to-day movements.
Fundamental Forecasting: Fundamental forecasting is largely based on the relationship between economic variables and exchange rate these variables includes – inflation rates, economic growth, productivity index, unemployment rates, balance of trade, etc. For example subjective assessments, quantitative measurements based on regression models and sensitive analysis. This technique is based on the assertion that the true value of the currency will be realized in the long run and therefore it is usually preferred by the long term investors. In general, fundamental forecasting is limited by:

(a). The economic factors changes overtime and no exact prediction of these factors can be done

(b). It is very important to assess the immediate impact of these factors on exchange rates

(c).Those factors which cannot be quantified should ignored in identifying the exchange rates

(d). Changes in sensitivity of currency movements to each factor overtime.

Market Based Forecasting: This technique uses market indicators to develop forecasts. The current spot/forward rates are often used, since speculators will ensure that the current rates reflect the market expectation of the future exchange rates.

Mixed Forecasting: It refers to the use of combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts developed.

Factors Influencing Exchange Rate Determination:

Exchange rates are determined by demand and supply forces. These forces are shaped by a number of factors such as:
(a). Inflation rates
(b). Interest rates
©. Fiscal Deficit
(d). Monetary Policy etc.