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., ...
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Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2010). Multinational Business Finance. (12th ed.). Boston, MA: Pearson Education, Inc.
Gharleghi, B., Shaari, A. H., & Shafighi, N. (2014). Predicting exchange rates using a novel “cointegration based neuro-fuzzy system.” International Economics, 137. http://dx.doi.org/10.1016/j.inteco.2013.12.001
Rogoff, K. (2009). Exchange rates in the modern floating era: What do we really know? Review of World Economics, 145(1), 1-12. http://dx.doi.org/10.1007/s10290-009-0006-5
Solnik, B. B. (1978). International parity conditions and exchange risk. Journal of Banking & Finance, 2(3), 281-293. http://dx.doi.org/10.1016/0378-4266(78)90017-1
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