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Effective Forecast Models for Exchange Rates: An Analysis of PPP and Ad-Hoc Approaches

This document explores various forecast models for exchange rates, focusing on the Purchasing Power Parity (PPP) and Ad-Hoc economic models. It examines the strengths and limitations of these methods, particularly the importance of understanding relative and absolute PPP, and the expectations hypothesis. The analysis highlights the necessity of integrating economic fundamentals and statistical methods to enhance prediction accuracy. For 2005, results indicate GBP at 1.8078 USD and JPY at 0.0096 USD, revealing the Ad-Hoc model as the most effective forecasting tool.

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Effective Forecast Models for Exchange Rates: An Analysis of PPP and Ad-Hoc Approaches

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  1. FINA 7386 – CASE 1 • Ntianu Okam • Chiedu Osuno • Ben Tuan

  2. FORECAST MODELS • PPP • FORWARD EXCHANGE RATES • MONETARY APPROACH • AD-HOC ECONOMIC MODELS

  3. CURRENCIES • USD • GBP • DEM • JPY • PESO • KOW

  4. MODEL ANALYSIS • PPP PROCESS • Based on law of one price • Issues • Ignores financial transactions • Absence of costs • Assumes prices and exchange rates flexible

  5. Relative PPP • Weaker version of Absolute PPP • Takes costs into account • Used to calculate the cost of Currency • Depreciates to PPP = overvalued • Appreciates to PPP = undervalued

  6. Why use PPP • Stable Long Run Predictions • PPP Exchange rates are better predictors of economic fundamentals across countries

  7. FORWARD EXCHANGE RATES Otherwise known as expectation hypothesis. Is not a regression model.

  8. MONETARY APPROACH States that Fx rates are asset prices traded in efficient markets

  9. AD-HOC MODEL • A fundamental approach to forecasting exchange rates. • Based on fundamental economic variables • Further modified through statistical means • It is a mixture of art and science

  10. RESULTS COMPARED - GBP

  11. RESULTS COMPARED - JPY

  12. MODEL OF CHOICE • Based on estimated RSQ, t-stat, and MAE, the Ad-hoc model will be the most effective to use. • Ad-Hoc spot rate forecast for 2005.04: GBP 1.8078 USD/GBP JPY 0.0096 USD/JPY

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