zmodel #007 – [PPP]

Click here to download: zmodel-007-PPP

In zmodel #007, we show how to forecast long-run exchange rates based on the Purchase Power Parity (PPP) theory.

Exchange rates are notoriously difficult to forecast in the short-run, with most models struggling to out-perform a random walk.

However for long-run forecasts, it is widely adopted market practice to adopt the PPP method in financial models. This theory states that in the long-run the exchange rate for an FX pair should be determined based on the relative price level between the two currencies. Therefore we can forecast long-run FX movements based on relative inflation levels.

 

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