Currency Movements: Here are three ways to forecast value of rupee.

An intense debate has been raging over the value of the Indian rupee, since it depreciated by more than 10% this year and recently breached a new low of 72 against the US dollar. Given the expected strengthening of the dollar, downward pressure on the value of the rupee (and other emerging market currencies) is expected to continue for some time. Since India imports huge quantities of oil, rupee depreciation also has an adverse impact on domestic inflation. With the Lok Sabha elections around the corner, it is a hot topic. This makes it important for investors to understand how to forecast the value of the rupee, also known as its exchange rate.

There are three approaches to exchange rate forecasting: Market-based forecasts, fundamental analysis and technical analysis.

We look at the price of the currency in the forward market (forward contracts trade in the derivatives market). As an example, if the rupee-dollar is currently trading at 72 and the one-year forward contract is trading at 75, we assume that it implies a depreciation of the rupee from 72 to 75. However, this approach can be misleading as the market consensus on the value of the rupee may be wrong or may change when new information becomes available. Savvy investors rarely rely on this approach.

The second approach, fundamental analysis, tries to forecast exchange rates by studying movements in the underlying economic factors which drive them. The most common variables which drive exchange rates are inflation and interest rates. Currencies of countries with high inflation and high interest rates usually depreciate over a period of time, although this relationship does not always hold. This approach can also be used to analyse the effect of monetary policy announcements on currency valuation. For medium-term forecasting, fundamental investors often use a popular demand-supply framework called the balance-of-payments (BoP) equation. The BoP is a systematic accounting record of all economic transactions during a period of time between residents of a country and residents in the rest-of-the-world. There are three components of the BoP: current account, capital account and official reserves account (special type of capital account).

The current account balance represents the net income of a country and incorporates the import-export balance, dividends, interest and unilateral transfers (like foreign aid). The capital account balance represents the net change in foreign assets (both real and financial assets) owned by the residents of a country. Finally, the official reserves account reflects the amount of international reserve assets owned by a country’s central bank. Each component of the BoP affects the demand and supply of a country’s currency. For example, every time an Indian company exports goods and services to USA, it receives payment in dollars, thus increasing the supply of dollars in the dollar-rupee market.

When exports increase, supply of the dollar goes up causing a decrease in the value of the dollar. Similarly, when Reserve Bank of India increases its foreign reserves by purchasing dollars, it increases the demand for dollars in the dollar-rupee market and creates depreciation pressure on the rupee. Tracking changes in the different BoP components is thus a useful approach for forecasting exchange rates.

The third approach, technical analysis, tries to forecast exchange rates using past data from currency markets, primarily related to price and volume. Technical traders use a variety of tools and techniques, including different types of charts, to identify price patterns and sustainable trends so that they can be exploited in the future. Charts like candlesticks, bar charts, line charts and point-and-figure charts are commonly used along with concepts like resistance levels, support levels, trends and breakouts to identify trading opportunities. Technical analysis can be employed effectively only in the short-term and requires sophisticated trading systems. Hence, this approach is usually unsuitable for retail investors.

While the three approaches can be useful in forecasting exchange rates, investors should remember that exchange rates also depend on a variety of non-economic factors like political uncertainty and geopolitical tensions around the world. The value of a currency is thus one of the most difficult economic variables to forecast.