Part III Exchange Rate Risk Management Information on existing and anticipated economic conditions of various countries and on historical exchange rate movements Information on existing and anticipated cash flows in each currency at each subsidiary Measuring exposure to exchange rate fluctuations Forecasting exchange rates Managing exposure to exchange rate fluctuations

Forecasting Exchange Rates 9 Chapter Forecasting Exchange Rates See c9.xls for spreadsheets to accompany this chapter. South-Western/Thomson Learning © 2003

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.

Efficient Markets Approach Financial Markets are efficient if prices reflect all available and relevant information. If this is so, exchange rates will only change when new information arrives, thus: St = E[St+1] and Ft = E[St+1| It] Predicting exchange rates using the efficient markets approach is affordable and is hard to beat.

Krugman and Obstfeld Paul Krugman and Maurice Obstfeld write in their book "International Economics: Theory and Policy” : If exchange rates are asset prices that respond immediately to changes in expectations and interest rates, they should have properties similar to those of other asset prices, for example, stock prices. Like stock prices, exchange rates should respond strongly to "news," that is, unexpected economic and political events; and, like stock prices, they therefore should be very hard to forecast Alan Greenspan: ‘To my knowledge no model projecting movements in exchange rates is superior to tossing a coin’

You will not make money To profit from exchange rate speculation you would have to be smarter than the markets. That requires years of experience and a bit of luck as well. If markets make the best use of information, and you do not have superior information, you cannot profit from exchange rate speculation. However, there is one scenario in which you can make a profit with great probability. Some governments maintain limited-flexible exchange rate regimes which are prone to realignments. You can profit from such realignments if you can correctly predict the timing of these events. Essentially, you are exploiting the fact that a government is working against market forces. The founder of Forbes Magazine once said: “You can make more money selling financial advice than following it.”

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. Clearly it is based upon the premise that history repeats itself, and thus it is at odds with the EMH

British Pound Week 35 2003

Technical Analysis

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 Approach Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps: step 1: Estimate the structural model. step 2: Estimate future parameter values. step 3: Use the model to develop forecasts. The downside is that fundamental models do not work any better than the forward rate model or the random walk model.

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.

Market-Based Forecasting Forward contracts may have low trading volumes and are not widely quoted for some currencies 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.

Performance of the Forecasters Forecasting is difficult, especially with regard to the future. 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 As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.

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.

Evaluation of Forecast Performance Using the Forward Rate as a Forecast for the British Pound Absolute Forecast Error ($)

Evaluation of Forecast Performance Mean Absolute Forecast Error Currency as a Percent of the Realized Value 1974-1998 1974-1984 1985-1998 British pound 4.61 % 5.06 % 4.21 % Canadian dollar 1.73 1.70 1.75 Japanese yen 5.60 5.22 5.93 Swiss franc 5.69 5.81 5.58

Forecast Bias If the forecast errors are consistently positive or negative over time, then there is a bias in the forecasting procedure. If the points appear to be scattered evenly on both sides of the perfect forecast line, then the forecasts are said to be unbiased

Using the Forward Rate as a Forecast for the British Pound Forecast Bias Using the Forward Rate as a Forecast for the British Pound Forward Rate Realized Spot Rate

Graphic Evaluation of Forecast Performance Perfect forecast line x z Realized Value Predicted Value Region of downward bias (underestimating) Region of upward bias (overestimating)

Graphic Evaluation of Forecast Performance Using the Forward Rate as a Forecast for the British Pound Realized Spot Rate Forecast (Forward Rate) Perfect Forecast Line

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