Changes in foreign exchange rates affect decisions made by businesses, investors, governments, and consumers. The rate of currency exchange between countries can impact the prices of goods and services, the supply and demand of financial assets, and interest rates. Additionally, fluctuations in foreign exchange rates can impact the bottom line of a business holding foreign exchange denominated investments. The significant impact exchange rates can have on the global economy suggests understanding how to forecast exchange rates is essential.
There are several methods in which foreign exchange rates can potentially be predicted which are based upon parity conditions, balance of payments, and the asset market. After an evaluation of each of these methods, an assessment will be provided suggesting the best approach for financial managers to utilize as they attempt to forecast exchange rates.
The law of one price suggests that identical goods sell for a single price regardless of the location of the market or the currency in which the good is denominated (Eiteman, Stonehill, & Moffett, 2010). When the prices across markets differ, arbitrage opportunities exist and arbitrageurs will buy and sell goods to return the market price to equilibrium (Bodie, Kane, & Marcus, 2011). Out of these arbitrage activities, various international parity conditions arise connecting exchange rates, interest rates, and price levels (Eiteman et al., 2010).
The purchasing power parity (PPP) theory suggests that, given the law of one price, the exchange rate can be determined based on an “individual set of prices” (Eiteman et al., 2010, p. 165). It relates the pricing of goods to the movement in inflation rates between countries (Eiteman et al., 2010). It further indicates a unit of currency in one country should equal the purchasing power of a unit of currency in another (Eiteman et al., 2010; Solnik, 1978).
Absolute PPP implies a similar group of goods provides the relative price for determining exchange rates (Eiteman et al., 2010). Similarly, Taylor (1995) noted the ratio of relevant price levels for two nations equals the exchange rate. Essentially, the current exchange rate is established based on the relative prices of a group of items (Eiteman et al., 2010). On the other hand, the relative PPP suggests that the current exchange rate cannot be determined through PPP (Eiteman et al., 2010). Instead, it suggests that exchange rates are influenced by changes in the relative prices between two countries over a period of time (Eiteman et al., 2010; Taylor, 1995).
The interest rate parity theory indicates that, excluding transaction costs, the forward rate varies from the spot rate by the interest differential between two countries (Eiteman et al., 2010). Essentially, there is no profit when the currency returns are equal (Eiteman et al., 2010). When interest rate parity does not exist, arbitrageurs will seek to restore equilibrium in the market...