Forex Rate Theory

In today’s economy, forex rate, the price of one currency in terms of another, has considerably contributed to the economic status of many countries all over the world. It is considered as one of the factors that identifies and emphasizes the welfare of a country; specifically, the welfare of its residents. With forex rate, a country can be provided with knowledge that may help them in different situations of interests. (Wright, n.d.)

According to Chand’s article, forex rate has some major types. These are the following:

1. Fixed Exchange Rate System

- This system, also known as Pegged exchange rate system, manages the steadiness of the exchange rate by fixing the exchange rate to a value of another currency or to another valuable measure

Macro fundamentals are believed by the economists to determine forex rates such that a nation’s currency directly affects economic growth rate, trade balance, inflation rate fall, and interest rate. He suggested two theories that can come up with a model for determining the forex rate. The first theory is the quantity theory of money. This theory states that an increase in money supply tends to increase the domestic price level and it can come up with a model for the long-run equilibrium of forex rate. However, this theory cannot take into account the fluctuations of forex rate. Hence, another theory called overshooting model by late Rudiger Dornbuschis was proposed. This theory explains that a currency appreciates more in the short-run than in the long-run. This can take into account the fluctuations of the forex rate. However, predicting the short-run is complicated and this is viewed by economists as a random walk. Short-run fluctuations are difficult to clarify because many factors are accounted to it. In addition, Becker & Wang (n.d.) asserted that forex is greatly affected by countries’ policies. Exchange rates acquire high volatility to which predicting the future movements of it is challenging and is at great risk. He explained that one bad predictor of the future forex rate is the forward rate. Forward exchange rate is about selling

Having knowledge on predicting forex rates truly helps the government in making policy decisions, people who are affected by foreign exchange risks, and families who are partly dependent on the remittances of their family member who works abroad. Mainly, forex rate greatly contributes to the global trade and investment by means of allowing transactions such as exchanging currency of an entity to a target currency in the determined forex rate. And also, Yu said, “it also provides the speculation and expedites the carry trade, in which there are substantial profits available. However, there also exists high risk in the speculation.” Usually, the random walk model is used in forecasting the forex rate. In spite of that, it has been argued that it is not consistent with respect to the theory behind forex rates (Becker & Wang, n.d.). Therefore, the objective of the study is to determine whether random walk model is still appropriate to use or other multivariate time series model is in predicting the forex rate. The predictors used under the study are as follows: domestic and foreign money supply, domestic and foreign output, domestic and foreign short-term interest rates, and domestic and foreign price levels. The study used monthly data from January 1998 to December 2008 for estimation and another data from January 2009 to December 2010 for evaluating the accuracy of the predicting result. Upon