Future Exchange Rates Forecasts

You work on the currency trading desk of a large international investment bank. Your boss has asked you to forecast what the exchange rates (USD/AUD, EUR/AUD and GBP/AUD) are going to be on 14 May 2019.

Foreign exchange market is a market place where trading in foreign currencies for various purposes such as speculation, arbitraging, and hedging takes place. In order make gains from trading in foreign currencies, it is pertinent for an investor to forecast the movements in the foreign currency in an appropriate manner. For this purpose, the investors can opt for various methodologies such as technical analysis, interest rate parity theory, and purpose price parity theory. In this context, a report has been presented here that deals with forecasting the foreign currency rates of USD, Euro, and GBP against AUD over a period of 12 months. Further, the report also presents the results of trading being done in the foreign currencies to make gains with AUD 100 million.

Technical Analysis

Under the technical analysis, the analyst analyzes the past movements in the rates of foreign currencies and based in this analysis, future currency rates are forecasted. A chart showing the trend in rate per AUD to USD, Euro, and GBP is given below: 

Figure 1: Rate per AUD over 5 years

[Data source: https://in.investing.com/currencies/aud-usd-historical-data]

All three currencies such as USD, Euro, and GBP have appreciated against AUD over the period of 5 years. In other words, it could be said that AUD has depreciated against USD, Euro and GBP over the period of 5 years. Summary of Growth rate is given in the table below:

It could be observed that appreciation in USD, Euro, and GBP has been 6.20%, 3.49%, and 2.50% respectively over 5 years period. Thus, the yearly appreciation in the rates comes to 1.59%, 0.88%, and 0.63% respectively for USD, Euro, and GBP. Applying these growth rates and assuming that the same will continue over the period of next 1 year, following forecast has been prepared:

Interest Rate Parity Theory

As per this theory, the foreign currencies rates can be forecasted applying the interest rates of two countries. The currency of country having higher interest would face depreciation against the currency of the country having lower interest rate. The forecasted rates of USD, Euro, and GBP against AUD for 1 year have been presented in the table given below:

The USD is depreciating against AUD while Euro and GBP are predicted to be appreciating over the 1 year time period as per IRPT.

Technical Analysis

Purchase Power Parity Theory

As per purchase power parity, the currency rates between two currencies can be predicted applying inflation rates of two countries. The country having higher rate of inflation would experience depreciation in its currency against the country having lower rate of inflation. The prediction of USD, Euro, and GBP against AUD applying IRPT has been presented in the table given below:

The foreign currency rate predicted above shows that USD and Euro are depreciating against AUD while GBP will appreciate in 1 year time period.

Speculating/ Arbitraging to Earn Profit

In order to devise the trading strategy, firstly, it is necessary to arrive at the predicted rates of foreign currencies for 1 year time period. For this purpose, average of prediction of rates by three method discussed above has been taken as shown in the table given below:

Now, it could be observed that based on the average figures, all three currencies such as USD, Euro, and GBP are predicted to be appreciating against AUD in 1 year time period. Based on this prediction, the trading strategy has been devised as shown in the table given below:

There is total AUD 100 million available for investment. The investment strategy has been devised in such as manner so as to reap out maximum benefits out of the investments. The weights of investment in USD, Euro, and GBP have been kept at 20%, 30%, and 50%. These weights have been decided having regards to forward depreciation of AUD against the respective currencies. It could be observed the highest depreciation is in GBP (0.77%), second highest is in Euro (0.46%) and then in USD (0.25%). Further, notable thing is that all investments might have been made in GBP having highest possibility of profits. However, this has not been done to achieve the diversification of risk.  

So, talking in absolute terms, a sum of AUD 20 million, 30 million, and 50 million has been appropriated for investment in USD, Euro, and GBP respectively. Applying the current spot rates, a sum of USD 15.40 million, Euro 18.90 million, and GBP 27.50 million has been bought. These foreign currencies have been sold at the end of 1 year at the predicted forward rates. The final outcome of the trading is profit of AUD 0.58 million. Thus, by utilizing the sum of AUD 100 million, the trader has been able to earn AUD 0.58 million.   

Conclusion

The report presented here talks about the currency forecasting mythologies and currency trading strategy. As regards currency forecasting methodologies, there have been identified three methodologies such as technical analysis, IRPT and PPPT. However, it is always advisable to use average of rates arrived at applying different methodologies to predict rates with more precision. The trading strategy makes a profit of AUD 0.58 million on the investment of AUD 100 millions in 1 year time period.