1. Chapter 12 Exchange Rate Forecasting

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To explain why exchange rate forecasting is needed. To illustrate forecasting techniques. To present empirical evidence on forecasting models.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Objectives (cont.) To explain how forecasters are evaluated. To demonstrate how technical analysis is used to generate buy and sell signals. To explain how filter rules and moving average rules work.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Definition Forecasting is a formal process of generating expectation. Expectations are implicit forecasts.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Why Do We Need Exchange Rate Forecasting? Spot speculation Uncovered interest arbitrage Spot-forward speculation Option speculation Hedging Investment and capital budgeting

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Why Do We Need Exchange Rate Forecasting? (cont.) Financing decisions Pricing decisions Strategic planning Macroeconomic conditions Central bank intervention

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Econometric Forecasting Models These are models that are specified on the basis of economic theory and estimated by an econometric method. They are classified into single-equation and multi-equation models.

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Single-Equation Models The exchange rate (or its rate of change) depends on one or more variables:

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Examples of Single-Equation Models

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Problems of Single-Equation Models The ‘black box’ problem Forecasting the explanatory variables Data frequency Structural changes Measurement errors Qualitative variables

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Multi-Equation Models The ‘black box’ problem can be solved by specifying a multi-equation model.

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 Time Series Models These are based entirely on the history of the exchange rate:

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 Problem with Time Series Models If the FX market is weakly efficient, the exchange rate must follow a random walk. Hence, it is not possible to forecast the exchange rate based on its history.

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Judgmental Forecasting Judgmental forecasting takes into account all factors affecting exchange rates. It is not based on a formula derived from a formal model.

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 Composite Forecasting Composite forecasting is based on two or more forecasts that are derived independently. Forecasting accuracy can be increased by pooling different forecasts.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 Combining Forecasts

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Why Composite Forecasting? Different forecasters have different degrees of forecasting accuracy. Diversification reduces the risk of large forecasting errors.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Forecasting Performance Evaluation Performance out of sample is more meaningful. The loss function is important.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Measures of Forecasting Accuracy Mean absolute error (MAE) Mean square error (MSE) Root mean square error (RMSE)

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Magnitude Versus Direction Sometimes it is more important to predict the direction rather than the magnitude of the change. The prediction-realisation diagram can be used to represent magnitude and direction errors.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 The Prediction-Realisation Diagram G C F D E B A H Line of perfect forecast Forecast change Actual change

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Technical Analysis This comprises a variety of practices and procedures used to forecast exchange rates. It ignores the role of fundamentals.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Rationale for Technical Analysis Exchange rates are determined by supply and demand. Supply and demand are governed by rational and irrational factors. Changes in trend are caused by shifts in supply and demand. History repeats itself.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Kinds of Charts Line charts Bar charts Point and figure charts

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 A Bar Chart Closing High Low S Time

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 Chart Formations Chartists study charts of exchange rate movements to identify certain patterns.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 Trendlines and Trading Ranges Trendlines connect ascending bottoms and descending tops. The market is in a trading range when the tops and bottoms are at the same level.

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Trendlines and Trend Channels S Time (a) Upward trend (bull market)

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 Trendlines and Trend Channels (cont.) S Time (b) Downward trend (bear market)

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 Trendlines and Trend Channels (cont.) S Time (c) Sideways trend (trading range)

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 Support and Resistance Levels A support level is the bottom of a market swing. A resistance level is a point where the market peaks and the exchange rate reverses an upward move.

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 Creation of Resistance and Support Levels Time S

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 Flags A flag is a continuation pattern. A flag occurs when a major trend is interrupted.

34. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 34 Triangles An ascending triangle appears when buyers come to the market at progressively higher levels. Otherwise it will be a descending triangle. A symmetrical triangle is difficult to interpret.

35. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 35 Head and Shoulders This formation indicates the reversal of an upward trend. A reverse head and shoulders formation implies the opposite.

36. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 36 Head and Shoulders (cont.) Head Neckline Shoulder Time S

37. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 37 Reverse Head and Shoulders Head Neckline Shoulder Time S

38. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 38 Market Efficiency and Trading Rules Market efficiency implies that it is not possible to make profit by adopting a mechanical trading rule or by following buy- sell signals extracted from charts.

39. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 39 Filter Rules An x% filter rule says that a currency is bought when it appreciates by x% from the most recent trough and is sold when it depreciates by x% from the most recent peak.

40. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 40 Single Moving Average Rule A single moving average rule says that a currency is bought when the moving average cuts the exchange rate series from above and is sold otherwise.

41. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 41 A Single Moving Average Rule

42. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 42 Double Moving Average Rule A double moving average rule says that a buy signal is indicated when the long moving average crosses the short moving average from above, and vice versa.

43. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 43 Empirical Evidence The evidence on trading rules is mixed. The FX market is highly, but not perfectly, efficient.