Risk Management: Ability to Forecast

Reading Brearly & Myers “Principles of Corporate Finance” 6th. Edition, Chapter 27 Blake “Financial Market Analysis” 2nd. Edition, Chapters 7, Appendix B Chapter 12 Ormerod “Butterfly Economics”

Categories For Forecasting General Economic Trends Specific Economic Series Prices in Financial Markets

General Economic Trends - Examples Population Age Distribution Overall Levels of Wealth An ability to forecast some general trends Bill Gates People overestimate the degree of technical change over the next year and underestimate it over the next decade. No company has dominate two phases of the computer revolution

Specific Economic Series Some are difficult to forecast Growth in GDP Average error on UK Treasury Forecasts 1.5%, Average Growth 2% For US National Bureau of Economic Research, Commercial Forecasts a Failure

The Determination of Exchange Rates An Example of Forecasting Financial Markets

Exchange Rate Arrangements 1 FreeManagedFixedSingle FloatFloatRateCurrency IndependentNo Economic Economic PolicyPolicy Independence No Intervention inIntervention inNo need to Forex MarketForex MarketsIntervene for no Market

Exchange Rate Arrangements 2 Free Managed FixedSingle Float FloatRateCurrency US PolandEuroland Switzerland BrazilLithuania Romania BelarusBarbados

Keeping Countries at Parities Using Reserves Running the Economy Interest Rate Adjustments Strongest Economy sets Policy

Problems of Forecasting Financial Markets Price Time Price t0 t1 a a b c c

Efficiency of Financial Markets Information is incorporated into price Past Price Information Publicly Available Information All Information Transactors in Markets on Average Should not be able to obtain abnormal returns

Theories of Exchange Rate Determination/Forecasting Fundamental - Economic Theories Technical - Psychological/Graphical

Forecasting the Future Fundamental Analysis -Underlying Economic Factors -Long Term Technical Analysis - Peoples Behaviour -Patterns are Replicated -Revealed By Charting Data -Short Term

Fundamental Analysis

Flows Approach to Forecasting - Forecasts Elements in Balance of Payments Asset Based Forecasting - Based on Choices on Assets - An evaluation of the value of the outstanding stock of a currency

Asset Pricing Theories - Monetary Theories

Asset Based Approaches 1 3.P = SP*Law of One Price Absolute Purchasing Power Parity Theory Price of Big Mac in Dollars April 1996 USA2.36 Argentina3.00 Britain2.71 Japan2.70 Switzerland4.80 Russia1.93 Poland1.44 China1.15

Law of One Price Criticisms Justified on Grounds of Trade Flows You can’t trade Big Macs Many goods not traded - Roof Tiles, Haircuts 90% of exchange rate transactions not trade related so price of goods not a consideration “Rip Off Britain”

Relative Purchasing Power Parity 1.E( St) = E(Pt+1) - E(P*t+1) Real Exchange Rates Fairly Stable in Longer Run In Short Run Real Rates Exhibit Less Stability (Note from here on P is used to denote inflation not price levels)

Relationship Between Spot and Forward Markets - Interest Rate Parity 2.(1 + i) = (1 + i*) F S 3. F - S = (i - i*) Approximately equal (i - i*) S 1 + i*

Uncovered Interest Rate Parity 4.Ft,1 = Et(St+1) 5.Ft,1 - St = E St+1 - St = i - i* St St

International Fisher Effects 6.it = Et(Pt+1) + Et(rt+1) Real Interest Rate Parity 7.E(rt+1) = E(r*t+1) 6.E St+1 - St = E(Pt+1) - Et(P*t+1) St

Asset Pricing Models - Dornbush Unexpected Monetary Expansion Interest Rate Falls Covered Interest Rate Parity Forward Premium Expect Rates to Rise Must be Overshooting

Asset Pricing Exchange Rate Forecasting What is the source of differential rates of Inflation ? Monetary Expansion - Increases in Aggregate Demand Issues of Time Lags and Adjustment Processes Role of Government - UK 1992

Example of Econometric Specification 10.St = a0 + a1mt + a2 m*t + a3yt +a4y*t + a5(it - it*) +a6st-1 Estimate equation then forecast RHS variables for forecast profile of Exchange Rate

Technical Analysis

Discernible Trends can be identified which depend on Investors Attitudes A Bag of Tools

Typical Market Cycle Price Time a b c d

Resistance and Support Levels Price Time Resistance Support a

Head and Shoulders Price Time

Elliot Waves Price Time a b c

Chartists Also Consider Trends Trading Volumes Moving Averages

Evaluation of Fundamental and Technical Analysis

Evaluation Fundamental Longer Term - Can one say what is the correct exchange rate ? Technical Short Term - One can make returns on Technical Analysis of Forex Markets However what is the correct tool is a problem with Technical Analysis

Exchange Rates Determined in Financial Markets Where floating may be very difficult to predict since Financial Markets Efficient Fundamental Theories Better in the Long Run Technical Theories Better in Short Run There may be Adjustment Issues

Concluding Remarks May be aware of overall trends as for example stocks Short term movements appear to be more intractable