Forecasting when Dealing with Foreign Currency

When a company is dealing with foreign currency, it is important to know the exchange rate and how it fluctuates. This is important for companies to keep up with the countries that they have monetary ties with. Many don’t think about the determents of the foreign exchange rates and what contributes to the rising and falling. It isn’t something easy to explain. There are three major schools of thought with each having individual drivers within that drive each approach. The three main approaches are the Purchasing Power Parity (PPP) approach, the Asset Market approach and the Balance of Payment (BOP) approach. These do not compete against each other, but complement each other. Some prefer one over the other or may even use a combination of them. This paper will briefly discuss each approach and how they relate to each other, while hopefully giving you some insight on which might be the best fit for your uses within your business.

The Approaches

Purchasing Power is the value of a currency expressed in terms of the amount of goods or services money can buy. Purchasing power is important because, if all else being equal, inflation decreases the amount of goods or services you'd be able to purchase. In order to measure purchasing power, you would have to compare against price index. An easy way to understand what purchasing power is to imagine if you made the same salary as your grandfather made and if you could survive on that. Obviously you could survive on much less than a few generations ago, however, because of inflation; you'd need a greater salary just to maintain the same quality of living. Many people can survive on a lower salary, but quality of living plays a big part as well.

The purchasing power parity (PPP) is a theory t...

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...as they can reflect assumption, insider trading, fraud, or poor decisions from central banks and governments but what is certain is that they create challenges for decision makers.

The exchange rate of the currency of a portfolio that holds the bulk of its investments determines what that portfolio's real return will be. A deteriorating exchange rate will decreases the purchasing power of income and capital gains resulting from any returns. Additionally, the exchange rate impacts other income factors to include interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous intricate factors that often leave even the most experienced economists baffled, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.