The dynamic relationship between price and exchange rates is well-documented. There are many causal mechanisms that link the two, each with its own implications. One explanation draws heavily on macroeconomics and trade theory while the other relies on the features of the forex market. First, a change of commodity index price would result in a change of the currency of the commodity. This could help to predict the movements of the exchange rates. The second explanation suggests a reverse view, where exchange rates can predict commodity prices.
This explanation is especially relevant for small open economies (SOE). The definition of small open economy is an economy that participates in international trade but is significantly smaller than its trading partners. Therefore, any changes in its policy do not affect or change global prices, incomes, or interest rates. Any small open economy that exports heavily on one commodity will see currency appreciation. This is because it causes an increase in domestic demand, which can lead to an increase in currency prices.
This theory states that it is possible to predict exchange rate movements using economic variables. Forecasting exchange rates can be difficult because of the differences between statistical evidence or empirical cogency and economic models that determine exchange rate movements.
In the short-term, higher commodity prices can lead to an appreciation in the domestic currency. This is due to an increase in forex supply in commodity exporters' markets as a result of an uptick of export revenues. This phenomenon could be exacerbated by foreign direct investment (FDI) in the medium-to long term due to better investment opportunities and prospects in the local or domestic commodity sector.
The changes in the export prices of commodity exporting countries are more important than the changes in their import prices. Therefore, fluctuations in the price of key export commodities can be regarded as a reliable proxy for changes in terms-of trade. There would be a dynamic relationship between commodity prices, exchange rates and their movements.
The second theory states that exchange rates, like all other asset prices are determined by the net present value (or NPV) of fundamentals. This includes commodity prices. Granger causality is a mathematical formula based on linear regression modeling stochastic processes. This theory states that exchange rates should cause commodity prices. This allows one to statistically analyze the movement of commodity prices based on movements in nominal exchange rates.
The theory is that global commodity prices can be predicted using the exchange rates of small commodity exporters. But commodity prices are often highly volatile and difficult to predict.
Numerous research papers were published. These papers included extensive studies that examined the relationship between commodity prices and exchange rates. These causal relationships were empirically examined using country-specific commodity export prices indexes (CXPIs), high-frequency data (daily, intra-day) and various other factors such as different horizons and daily and 5-minute data on nominal exchange rates, commodity spot price, S&P 500 index price, short-term interest rates and non-U.S. dollars exchange rates. The vector autoregressive moving average (VARMA), or random-walk model have been used to forecast linearly.
It is possible to determine the strength of the links between commodity prices and exchange rates by estimating the causality measures at various horizons in each direction. There was evidence of a strong, solid, and dynamic relationship between commodity price and exchange rate. Granger-causality exists between commodity prices in both directions. It is possible to calculate exchange rates by using commodity prices and other factors, such as the interest rate. Exchange rates can also be used to predict future commodity prices. Studies have shown that the measured strength of commodity prices can be used to predict future exchange rates (direction commodity prices to exchange rate), especially at short horizons.