Exchange Rate Forecasting Analysis - Essay Example

Introduction Today, we are living in the world of globalization where national economies have continued to become integrated in many ways. As such, the exchange rate has become the relative price in the open economies. It has thus become an important point of consideration when making major investment. The ability to be able to predict the performance of different currencies is a one of the secret of success in the forex market. One of the way information of the future performance of exchange rates is thought studying past patterns. Predicting the performance of different currencies in the market can help both individuals and investors in making sound business decision to minimize risk and maximize returns on investment (Oberlechner, 64). This paper focuses on a case studies related to exchange rate forecasting. A leader in a certain firm who has had keen interest on the exchange market and studied it predicts that in the next 12 months the exchange rate between the dollar and the Euro will be $1.41 to Euro. The company seeks to invest $ 500 000 in the forward, spot or options market. Using the current performance in the market, the forward rate is $1.37o5 to the Euro and the spot rate is $1.3435. This article discusses why the firm leader predicts that there will an increase in the exchange rate, seeks to calculate the profits that can be earned from the investment and gives recommendations on investments based on speculations. How to make Prediction on Future performance of the currencies in the exchange rate market One of the ways that can be used to predict future performance is by the use of Purchasing Power Parity (PPP). This is the most commonly used method and is based on the theory of one price where the prices of a identical commodities are assumed to have the same price in different countries. This means that if the rate of inflation in one country if higher than the rate of inflation in another country is lower, then the value of the currency with a higher rate of inflation will reduce in relation to the currency of the country with lower inflation. For instance, in this case study, the increase in value of euro could be as a result of increase in the rate of inflation in America in relation to inflation in the euro zone. For instance, if the predicted increase in inflation in America for the next 12 months is 5% and the expected increase in rate of inflation in the euro zone is 2% then the difference in inflation rates is the level of depreciation the American dollar currency suffers in relation to the dollar (Yu et al 245). 5%-2%= 3% difference in inflation rates. If currently the value of the euro is $1.5 then the new exchange rate will be: $1.5 ? 103%= $ 1.545 1 euro will exchange for $ 1.545. Another way the leader could have predicted an increase in the value of euro in relation to the dollar could be through the prediction of the relative economic growth rate. The value of a nation’s currency is expected to appreciate if the country has a good economic growth outlook with likelihood of greater domestic and foreign investment. American just experienced a government shutdown which is a phenomenon that is expected to influence investment negatively. Both foreign and domestic investors may not be willing to make huge investment under the unsure circumstances and this is expected to stunt economic growth rate (Yu et al 243). The euro zone is not experience anything like this and their economies are expected to continue growing. It is thus possible that the value of the euro will increase in relation to that of the dollar. Calculation of the Expected profits The spot rate is $ 1.3435 Forward rate $ 1.3705 $1.3705-$1.3435= $0.027 Percentage increase in rate: 0.027?1.3435? 100= 2.01% Expected profit $500 000? 2.01%=$ 10050 Recommendation on Investment Making investments in the speculative market brings about a lot of income within short period of time. It is also less involving as it does not require labor but being able to predict the market performance. Nevertheless, if a person makes the wrong prediction, they can end up losing all their investment in this market. Moreover, predicting the exchange rate is not a very easy task and these methods have not been seen to always work. There are very many factors that affect exchange rates. In order to invest in currency, one need to conduct adequate research on the markets and the risks involved to know how to mitigate them (Oberlechner, 65). We are living in a market environment that is highly unpredictable and this can affect exchange rates in manners that cannot be compared to patterns in the past. However, the risk involved is greater than when one invests in more predictable ventures such as real estate. Besides the exchange rate risk, investment in the forex market comes with other risk such as political disruption and local tax implications. The political climate in the foreign country can create portfolio risk because the governments are constantly changing and this disrupts the business and economic sectors. The forex market is very dynamic and a very small change can have very huge impact on one’s investment. Moreover, the forex markets are open 24 hour a day and this requires one to be committed in spending a lot time monitoring their investment to track the movements. There are risk management systems that are used by investors of the currency market such as the stop-loss orders. However, these only give limited immunity and do not completely safeguard the investment from losses coming from unforeseen circumstances (Frankel, 276). In addition, one may be requirement to pay some form of premium to get this protection which makes such an investment less worthwhile. As has been observed, investing in forex exchange is a very risk and complex. Making good predictions about the market performance has continues to be a challenge even for experienced business people who have been in the industry for a long time. If one is not prepared for the risks, it is better to invest in other non-predictive ventures such as selling of products or providing services that are easy to monitor by measuring the forces of demand and supply. Although there are models that have been developed to predict performance of different currencies, these predictions are not always accurate since they factors affecting these market are diverse and are not all taken into account by the model. However, this forex market is an area that one can make a lot of money and this depends on both luck and good prediction. Work Cited Frankel, Jeffrey A, Giampaolo Galli, and Alberto Giovannini. The Microstructure of Foreign Exchange Markets. Chicago, Ill: University of Chicago Press, 1996. Internet resource. Yu, Lean, Shouyang Wang, and Kin K. Lai. Foreign-exchange-rate Forecasting with Artificial Neural Networks. New York: Springer, 2007. Print. Oberlechner, Thomas. The Psychology of the Foreign Exchange Market. Chichester: John Wiley & Sons, 2005. Internet resource. Read More