Forecasting Exchange Rates 9 Chapter Forecasting Exchange Rates

Chapter Objectives To explain how firms can benefit from forecasting exchange rates; To describe the common techniques used for forecasting; and To explain how forecasting performance can be evaluated.

Why Firms Forecast Exchange Rates MNCs need exchange rate forecasts for their: hedging decisions, short-term financing decisions, short-term investment decisions, capital budgeting decisions, long-term financing decisions, and earnings assessment.

Forecasting Techniques The numerous methods available for forecasting exchange rates can be categorized into four general groups: technical, fundamental, market-based,and mixed.

Technical Forecasting Technical forecasting involves the use of historical data to predict future values. It includes statistical analysis and time series models. Speculators may find the models useful for predicting day-to-day movements. However, since they typically focus on the near future and rarely provide point/range estimates, they are of limited use to MNCs.

Fundamental Forecasting Fundamental forecasting is based on the fundamental relationships between economic variables and exchange rates. A forecast may arise simply from a subjective assessment of the factors that affect exchange rates. A forecast may be based on quantitative measurements (with the aid of regression models and sensitivity analysis) too.

Fundamental Forecasting Known relationships like the PPP can be used for the regression models. However, problems may arise. In the case of PPP: the timing of the impact of inflation on trade behavior is not known for sure, prices may be measured inaccurately, trade barriers may disrupt the trade patterns that should emerge, and other influential factors may exist.

Fundamental Forecasting In general, fundamental forecasting is limited by : the uncertain timing of the impact of the factors, the need for forecasts for factors with instantaneous impact, the possibility that other relevant factors may be omitted from the model, and changes in the sensitivity of currency movements to each factor over time.

Market-Based Forecasting Market-based forecasting involves developing forecasts from market indicators. Usually, either the spot rate or the forward rate is used, since speculation should push the rates to the level that reflect the market expectation of the future exchange rate. Since forward contracts have low trading volumes and are not widely quoted, the interest rates on risk-free instruments can be used to determine what the forward rates should be according to IRP for long-term forecasting.

Mixed Forecasting Mixed forecasting refers to the use of a combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts developed.

Forecasting Services The corporate need to forecast currency values has prompted some consulting firms and investment banks to offer forecasting services. Advice on hedging and international cash management, and assessment of the firm’s exposure to exchange rate risk, may be provided too.

Forecasting Services One way to determine whether a forecasting service is valuable is to compare the accuracy of its forecasts with the accuracy of publicly available and free forecasts.

Evaluation of Forecast Performance An MNC that forecasts exchange rates should monitor its performance over time to determine whether its forecasting procedure is satisfactory. The MNC may also want to compare the various forecasting methods.

Evaluation of Forecast Performance One measure of forecast performance is the absolute forecast error as a percentage of the realized value: | forecasted value – realized value | realized value Over time, MNCs are likely to have more confidence in their forecasts when they know the mean error for their past forecasts.

Forecasting Under Market Efficiency If the foreign exchange market is weak-form efficient, then the current exchange rates already reflect historical information. So, technical analysis would not be useful. If the market is semistrong-form efficient, then all the relevant public information is already reflected in the current exchange rates.

Forecasting Under Market Efficiency If the market is strong-form efficient, then all the relevant public and private information is already reflected in the current exchange rates. Foreign exchange markets are generally found to be at least semistrong-form efficient.

Forecasting Under Market Efficiency Nevertheless, MNCs may still find forecasting worthwhile, since their goal is not to earn speculative profits but to use exchange rate forecasts to implement policies. In particular, MNCs may need to determine the range of possible exchange rates in order to assess the degree to which their operating performance could be affected.

Exchange Rate Volatility MNCs also forecast exchange rate volatility. This enables them to specify a range (confidence interval) and develop best-case and worst-case scenarios along with their point estimate forecasts. Popular methods for forecasting volatility include: the use of recent exchange rate volatility,

Exchange Rate Volatility the use of a historical time series of volatilities (there may be a pattern in how the exchange rate volatility changes over time), and the derivation of the exchange rate’s implied standard deviation from the currency option pricing model.

Impact of Forecasted Exchange Rates on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Technical Forecasting Fundamental Forecasting Market-based Forecasting Mixed Forecasting