Level III Core · Capital Market Expectations, Part 2: Forecasting Asset Class Returns

Forecasting Exchange Rates for CFA Level III

Updated 9 October 2026 · Fact-checked

Forecasting exchange rates means estimating the future spot rate using PPP, interest rate parity and capital and trade flows. Relative PPP predicts the currency with higher inflation depreciates. Covered parity gives the forward rate. Uncovered parity says the expected spot change equals the interest rate differential. Apply the formula, then adjust for flows.

Understand Forecasting Exchange Rates

An exchange rate is the price of one currency in terms of another. Quote it as price currency per base currency, written P/B. A rise in S(P/B) means the base currency appreciates. Most forecasting errors start with confusing which currency is the base, so fix the quote first.

Absolute PPP says the same basket of goods costs the same in both countries once converted: S(P/B) = CPI(P) ÷ CPI(B). It rarely holds because of transport costs, taxes, tariffs and non-traded goods. Relative PPP is about changes. The currency of the country with higher inflation is expected to depreciate by about the inflation difference. Relative PPP works poorly over short horizons and better over long ones, so it is used as a long-run anchor, not a short-term forecast.

Covered interest rate parity is a no-arbitrage condition. You can lock in the forward rate, so the forward premium or discount must offset the interest rate difference. The currency with the higher interest rate trades at a forward discount. It holds closely in practice, so it tells you the forward rate, not necessarily where spot will go. Uncovered interest rate parity replaces the forward rate with the expected future spot rate. It says the expected currency change equals the interest rate differential, so the higher-yielding currency is expected to depreciate. Empirically it often fails. High-yield currencies have tended to do better than UIP implies in many periods, which is the basis of the carry trade, and carry trades carry crash risk.

International Fisher effect combines real rate equality with relative PPP: nominal rate differences reflect expected inflation differences. Real rates are assumed equal across countries.

The balance of payments approach adds flows. Current account deficits must be financed by capital inflows. If inflows weaken, the deficit currency tends to fall. Capital flows driven by growth prospects, rate changes and risk appetite can push a currency far from PPP for years. Other drivers are monetary and fiscal policy mix, and a risk-off move that favours safe-haven currencies. In practice, analysts use PPP for the long-run anchor, parity relations for the near-term baseline, and flows and policy for tilts. Always state which view you are using and why.

Key rules to remember

Absolute PPP: S(P/B) = CPI(P) ÷ CPI(B); Law of one price applied to a basket. Holds only loosely in practice.
Relative PPP (approximate): %ΔS(P/B) ≈ π(P) − π(B); Currency with higher inflation depreciates. Base currency rises if price-country inflation is higher.
Relative PPP (exact): S(t+1) = S(0) × (1 + π(P)) ÷ (1 + π(B)); Use when the question gives precise inflation rates or a long horizon.
Covered interest rate parity: F(P/B) = S(P/B) × (1 + i(P)) ÷ (1 + i(B)); Same horizon for rates and forward. Higher-rate currency trades at forward discount.
Forward premium or discount: F − S ≈ S × (i(P) − i(B)); Approximation. If i(P) > i(B), then F(P/B) > S(P/B), so the price currency is at a forward discount and the base currency is at a forward premium.
Uncovered interest rate parity: E[S(t+1)] = S(0) × (1 + i(P)) ÷ (1 + i(B)); Expected spot equals the covered forward in theory. Often fails empirically.
International Fisher effect: i(P) − i(B) ≈ E[π(P)] − E[π(B)]; Assumes equal real rates across countries.

How to solve Forecasting Exchange Rates questions

Use this method for any exchange rate forecasting question, calculation or conceptual.

1Write the quote as P/B and name the base currency. Decide what a rise in the rate means.
2Identify the horizon and which input is given: inflation rates, interest rates or flow data.
3Choose the relation. Inflation data means relative PPP. Interest rates and a no-arbitrage forward means covered parity. Interest rates and an expected spot means uncovered parity.
4Compute with the exact formula, with the price currency rate on top and the base currency rate below. Match the period of the rates to the horizon.
5Check direction: the higher-inflation or higher-rate currency should depreciate (or trade at a forward discount). If not, you inverted the quote.
6State the result in the form asked: rate, percentage change or direction. Add one line on caveats such as PPP being long-run only or UIP often failing.
7If asked for a recommendation, tie it to flows, policy and the client's currency exposure, and say which approach you are weighting.

Quickest way: Ratio of (1 + rate) or (1 + inflation)

When to use it: Any numeric question giving two inflation rates or two interest rates and a spot rate.

Write S × (1 + price-currency rate) ÷ (1 + base-currency rate).
Use inflation rates for PPP and interest rates for parity. The structure is identical.
Type the number on its own. A correct number typed on its own earns full credit for a calculation.
Sanity check: higher rate or inflation in the price currency should raise S(P/B), meaning the base currency strengthens.

Common mistakes in Forecasting Exchange Rates

Inverting the currency quote, so the price currency's higher inflation is treated as strengthening it.
Students forget that S(P/B) is price currency per unit of base currency.
Fix: Write P/B first. Higher price-currency inflation raises S(P/B), meaning the price currency depreciates.
Claiming UIP and covered parity are the same thing.
Both use the same formula structure.
Fix: Covered uses the forward rate and is a no-arbitrage condition. Uncovered uses the expected spot and has no arbitrage enforcement.
Saying relative PPP is a reliable short-term forecast.
The formula looks precise.
Fix: State that PPP deviations can persist for years. It is a long-run anchor.
Expecting the high-interest currency to appreciate under parity.
Confusing yield attraction with parity logic.
Fix: Under parity, the higher-rate currency is at a forward discount and expected to depreciate. Empirically, carry trades earn the yield, so note the contradiction.
Mixing absolute and relative PPP.
Names are similar.
Fix: Absolute is about price levels. Relative is about rates of change in prices.
Ignoring flows when asked to justify a forecast.
Students stop after the formula.
Fix: Add balance of payments, capital flows and policy to adjust the parity-based baseline.

Worked examples

Example 1

Spot USD/EUR is 1.2000 (USD per EUR). Expected annual inflation is 4% in the US and 1% in the euro area. Using relative PPP, what is the expected USD/EUR rate in one year?

Show the solution

Price currency is USD, base is EUR. Higher US inflation means USD should depreciate, so S(USD/EUR) should rise.
S(1) = 1.2000 × (1.04 ÷ 1.01).
1.04 ÷ 1.01 = 1.029703.
1.2000 × 1.029703 = 1.23564.

Answer: About 1.2356 USD per EUR. The USD is expected to depreciate by roughly 3%.

Example 2

Spot is 0.8000 GBP/CHF (GBP per CHF). One-year interest rates are 5% in GBP and 2% in CHF. Find the one-year covered-parity forward rate and say what UIP would predict for the expected spot rate.

Show the solution

Price currency is GBP, base is CHF.
F = 0.8000 × (1.05 ÷ 1.02).
1.05 ÷ 1.02 = 1.029412.
F = 0.8000 × 1.029412 = 0.82353.
GBP has the higher rate, so it trades at a forward discount; CHF is at a forward premium.
UIP sets the expected spot equal to this value, so E[S] is 0.8235, implying GBP depreciates about 2.9%.

Answer: The forward is about 0.8235 GBP/CHF. UIP predicts an expected spot of 0.8235, but in practice the high-yield GBP often does not depreciate that much, which is why carry trades can earn a return.

Exam tips

Write the quote direction first in every essay. Many lost points come from reversing it.
For compare or distinguish questions, give one distinguishing line each: covered is arbitrage-enforced, uncovered is an expectation and often fails.
When asked to justify a currency view, name the anchor (PPP), the baseline (parity) and one flow or policy factor.
Only the number of responses asked for is graded, in order. If asked for two factors, give exactly two.
For calculations, a correct number typed on its own earns full credit, so double-check the number and the quote direction.

Forecasting Exchange Rates in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Forecasting Exchange Rates: frequently asked questions

What is the difference between absolute and relative PPP?

Absolute PPP says the exchange rate equals the ratio of price levels. Relative PPP says the percentage change in the exchange rate equals the inflation differential. Relative PPP is the version used for forecasting.

What is the difference between covered and uncovered interest rate parity?

Covered parity links spot, forward and interest rates through no-arbitrage, so it holds closely. Uncovered parity assumes the expected future spot equals the forward rate, with no hedge. It often fails, which is why carry trades exist.

How do I forecast currency returns for a portfolio?

Start with a baseline from parity or PPP, then adjust for balance of payments flows, policy and risk sentiment. State the horizon and tie the view to the portfolio's currency exposure.

Does higher inflation always weaken a currency?

Relative PPP says it should over the long run, but over short horizons other factors such as capital flows and interest rates can dominate. Present PPP as a long-run anchor, not a timing tool.