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Foreign Exchange Memo

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To predict the value of the Euro for November 15th 2010, the first step will be to get the current exchange rate and the current inflation rate for the two regions.

  • The current rate for 1 USD = 0.7146 Euro (using yahoo finance currency converter).
  • We will assume an inflation rate of 1.1% for US  and (1.15% for the Euro countries

The next step will be to adjust for the equivalent of the Euro in the US dollar rate. Thus:

(1.1%/1.15%)-1 = -0.434= 4.34 % appreciation.

The US dollar relative to the Euro will appreciate by 4.34% per annum which translates into 0.36 percent per month. Thus the Euro will depreciate by 0.36 percent when compared to the USD:

Thus in a month from now and based on the above assumptions o a USD will be equivalent to (1-.36)* 0.7146 = 0.7120

1 USD= 0.7120 EURO 

The calculation is based on the Purchasing Power parity rate (PPP).  The calculation assists in predicting if the foreign currency will appreciate or depreciate against the domestic currency and in knowing the correlations between the two currencies. The PPP rate represents the purchasing power of the two different countries. PPP is the rate that is used with the assumption that the exchange rate between two currencies is equivalent to the ratio between the prices of goods in the two countries. It is based on the fact that the rate of inflation in a country will affect the purchasing power of the country and the currency of the affected country is devalued. The rate of devaluation of the currency is the same as the difference in the rate of inflation for the said country. One of the advantages of using PPP in predicting the future exchange rate is its relevance in comparing the exchange rates without using the inflation rate for the different countries, which is a real indicator conversion factor. 

The correctness of this exchange rate will depend on other factors as it is hard to predict the future exchange rates as there are factors that may affect the exchange rates. A major event or news in USA or one of the Euro countries may affect the economy of the region which may in turn affect the rate of inflation and hence the change in the exchange rate. There are other factors that should be highlighted while predicting the future exchange rates. One of these factors is that the figures in use are historical figures which are arrived at by evaluating the past and using the data from the history of what happened and using the same information to predict the future rates. The problem with historical data is that the circumstances in the historical events may be different as compared to if the same events were to be repeated in the future. Thus the predicted figures should only be relied on as estimates for future planning. There should be an allowance for error to make the estimates more reliable.

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There are two approaches in predicting the future currency rate, the fundamental approach and the technical approach. The fundamental approach is usually applied for long term currency predictions using the countries’ GDP, inflation rate, consumer price index (CPI) and balance of trade rates. The long term predictions methods include the purchasing power parity (PPP), the interest rate parity methods. The technical approach basis its predictions on the market sentiments. Exchange rates in the short term are affected by the news and events that may have an effect on the exchange rates and the market sentiments which changes the countries economic prospects. There are several factors that affect the exchange rate of a country, among them the interest rates, the bank policies, and current news and events of the day. The prediction of the short term exchange rate in most cases will be affected by the daily news and events. The methods used for technical approaches will include positioning surveys, moving-average trend following trading rules and FX dealer customer flow data. The technical methods will include a filtering of the daily fluctuations which result from the news and events, to come up with a longer lasting trend of the currency trend. Recently technology has made it easier to predict the exchange rates for a specified future period.

The different approaches can be applied in three forms, the forecasting of an event timing which is usually preferred for valuation and devaluation of fixed exchange rates; the forecasting event outcome which focuses on aligning of the currencies and in deciding which currency will be valued and which will be devalued, the third method is time series forecasting. Time series forecasting is applied in getting the value of currency for a specified time period. This method considers the variables which may affect the exchange rate.

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