Many traders or financial institutions who invest a lot of capital in forex market have ways to forecast fluctuations of currencies. These ways make trading important because it will help traders to maximise returns and minimise losses and risks. There are ways to predict currency changes, and there is no research that has been made to show another way is superior to the other. Most investors use four popular methods.
The popular method is purchasing power parity. It is popular because its indoctrination is available in many forex textbooks. These ways is based on the theoretical law of price. The law states that identical goods in several countries should have same prices. For example, the law claims that the pen in Canada should cost the same in the US. The price should be inclusive of shipping costs and exchange rates. It claims that there is no point where one can buy the goods cheaper in one country than the other. This approach takes care of inflation. For example, if the inflation rate in the US is 4% and the inflation rate in Canada is 2%, the difference is 2%. This means that the prices in the US should drop by 2% to make the price of two countries relatively equal.
Another way is through Relative Economic Strength Approach. This method look at the strength of the economic performance of certain countries to forecast on the direction of currencies fluctuations. This way claim is that the strong economic environment of a certain country will attract more foreign investors. The investments of that certain country will definitely be high. For an investor to invest in that particular country, it is definitely they will purchase the currency. This will increase the demand of currency of that certain country. This approach also takes care of the general view of the investment flows in many countries. This approach will not forecast how the exchanges rate will be like the former.
The other way is through econometric models. This involves gathering all the factors that might affect the price of the currency in the market. After identifying this factors, investors will develop a working model that relates these factor to the foreign exchange rate. Many econometric models depends on the existing economic theory. Any variable will be added if it significantly affect the foreign exchange rate. This method is time consuming, but once a working model is built, it will make it easy for an investor to enter data and variables when they happen.
The last way is Time Series Model. This method is technical in nature. It is purely not based on economic theory. The popular method under this category is autoregressive moving average (ARMA) process. This method claims that past currency pair and patterns can be used to predict future currency pair and patterns. The data is required that is usually in series and then enter it into a computer program. It will help the investor to approximate the parameters and create a model that is right for one. For an investor who wants to learn how to forecast this method will be useful.