Interest Rate Approach
We can determine or predict exchange rates by analyzing interest rate differentials via a few principles. Assuming that the expected returns of a currency should be equalized through speculation in another country once converted back to the first currency, the theory of interest rate parity holds, where:
Interest Rate Differential = Exchange Rate’s Forward % Premium / Discount
We know from PPP principles that exchange rates and inflation rates are linked, therefore if explained via the Fisher effect, we arrive at the following conclusion:
Therefore:
Difference in spot and forward rates = Expected change in Spot Exchange Rate
The link or correlation between real interest rate differentials and the exchange rate appears to have grown since the liberalization of global capital flows. Therefore, capital flow has grown exponentially important relative to that of trade flow and currently, currency strategists across the market continue to track this relationship between real interest rate differentials and nominal exchange rates as one of the many useful and important indicators of currency over- or undervaluation.