In Forex trading, there are so many terms and each of them has a specific description and use. Without knowledge of how it works, you cannot use its full advantage. That being said, it is important to understand some terms used in Forex.
Forecasting is a term used in Forex which refers to the technique by which historical data is being utilized to estimate data and pinpoint the right direction of the trends in the future. In businesses, they use forecasting to pinpoint the proper budget or when they are planning for the expenses over a period of time. The data is particularly projected according to the demand of services and goods being offered.
Three Ways To Forecast Changes in The Currency
Purchasing Power Parity
Also called PPP or Purchasing Power Parity (PPP) is a very popular forecasting method, thanks to its constant feature in some well-known economic textbooks. The PPP method is based on the law of one price theoretical approach. It states that identical goods from different countries should still have the same prices.
For instance, the pencil bought in Canada should have the same price as the ones bought in the United States. This is possible by taking into account the transaction cost, shipping costs, and exchange rate. This implies that there should not be any arbitrage opportunity when someone buys an inexpensive pencil in Canada and is sold pricey in the United States to gain some profits.
Relative Economic Strength
Just like its name, the main approach of Relative Economic Strength is the economic growth of different countries. Forecasting the economic growth is done to be able to point out where the direction of the exchange rate will go. The main rationale of this method is the idea that a country with a strong economy and constant high growth is most likely to adopt more investments from investors from other countries. But to be able to buy these investments, the foreign investor will first have to purchase the currency of the country where they want to invest in, which in turn, increases the demand for currency causing it to appreciate.
Econometric Models of Forecasting Exchange Rates
Econometric models are another commonly used forecasting method that involves the gathering of several factors affecting the movement of the currency and creating a model that is related to the variable of the exchange rate. Additionally, the factors being used in this method are from economic theory.
For you to use the forecasting method in Forex trading, you have to be knowledgeable enough about this industry. Forecasting is such a tough task and it requires so much data to absorb. For this reason, even huge financial companies just prefer to hedge their trading risk than enter this tricky game. But for those who are more familiar with forecasting exchange rates, reap the benefits of their hard work. You just have to be careful when forecasting and educate yourself beforehand to avoid miscommunication later on. There are a couple of forecasting topics and educational tools online. Check them out for reference.