Implementing a PPP-based Forecasting System

For purposes of the simulation and illustrations presented on these pages, we have employed the simplest and most straightforward versions of the many possible data series that are available or can be constructed. We always use the CPI, for example, to calculate infomation, and we use a 60-month historical window (where appropriate). We chose to take this simplified approach to demonstrate that even with these parameters, our PPP-based system is robust enough to provide good results in forecasting currency movements.
Readers are invited to experiment with alternative measures (such as using export prices instead of consumer prices), or by varying the time window used as an historical reference base, but the methodology we describe will work very well, in our experience, in all markets, by employing only the most basic data. Naturally, improvements are possible by studying the unique characteristics of each country and market, but these incremental benefits are, in our perception, marginal in nature compared with the overall benefit of using the basis approach we advocate. Using export prices or fiddling with the time window will improve results in some countries. We have found, for example, that there is generally a correspondence between the length of the window and the volatility of the currency- more volatile markets need more observations to collect a representative statistical sample.
We do not mean to suggest that these refinements are a waste of time, quite the contrary, we are constantly searching for ways to improve our calculations. The incremental value added will come in basis points, however, not in percentage points. So these subtle modifications are only that - improvements at the margin, or in other words, the kind of tinkering that quants love to do with their models, but that add just a few basis points per year to returns.
Our methodology is based on our belief that Purchasing Power Parity (PPP) theory describes market behavior over long periods of time, that is to say; currency exchange rates will ultimately reflect relative changes in price levels between countries. Having said that, however, we admit to begging the questions: "how long?", and "which prices?"