1. 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

2. Forecasting Exchange Rates9
Chapter
Forecasting Exchange Rates
See c9.xls for spreadsheets to accompany this chapter.
South-Western/Thomson Learning © 2003

3. 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.

4. 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.

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

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. Market-Based Forecasting
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.

12. 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.

13. Online Application
Visit for reviews of international political and economic events and their presumed global impact. The site also presents economic and political analyses of major economies.
Country outlooks and exchange rate forecasts can also be found at

14. 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.

15. 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.

16. 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.

17. 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.

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

19. Evaluation of Forecast Performance
The ability to forecast currency values may vary with the currency of concern.
In particular, the value of a less volatile currency is likely to be forecasted more accurately.

20. Evaluation of Forecast Performance
Mean Absolute Forecast Error
Currency as a Percent of the Realized Value
British pound 4.61 % 5.06 % 4.21 %
Canadian dollar
Japanese yen
Swiss franc

21. Forecast Bias
If the forecast errors are consistently positive or negative over time, then there is a bias in the forecasting procedure.

22. 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

23. Forecast Bias
The following regression model can be used to test for forecast bias:
realized = a0 + a1 ´ forecast + m
If a predictor is found to be biased, the estimated a0 and a1 values can be used to correct the systematic error.

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

25. 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

26. Graphic Evaluation of Forecast Performance
If the points appear to be scattered evenly on both sides of the perfect forecast line, then the forecasts are said to be unbiased.
Note that a more thorough assessment can be conducted by separating the entire period into subperiods.

27. Comparison of Forecasting Techniques
The different forecasting techniques can be evaluated
graphically - by comparing the distances from the perfect forecast line, or
statistically - by computing the mean of the absolute forecast errors, and then using a t-test or a nonparametric test to determine whether there is a significant difference in the accuracy of the forecasting techniques.

28. 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.

29. 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.

30. 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.

31. 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,

32. 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.

33. Online Application
Various foreign exchange resources, including exchange rate volatility based on historical exchange rate movements, can be found at and

34. Application of Exchange Rate Forecasting to the Asian Crisis
Before the crisis, the spot rate served as a reasonable predictor, because the central banks were maintaining a somewhat stable value for their respective currencies.
But even after the crisis began, it is unlikely that the degree of depreciation could have been accurately predicted by the usual models.

35. Application of Exchange Rate Forecasting to the Asian Crisis
The large amount of foreign investment and the fear of a massive selloff of the currencies played key roles in the sharp decline of the Asian currency values.
However, these two factors cannot be easily incorporated into a fundamental forecasting model in a manner that will precisely identify the timing and magnitude of currency depreciation.

36. 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

37. Chapter Review Why Firms Forecast Exchange Rates
Forecasting Techniques
Technical Forecasting
Fundamental Forecasting
Market-Based Forecasting
Mixed Forecasting
Forecasting Services
Performance of Forecasting Services

38. Chapter Review Evaluation of Forecast Performance
Forecast Accuracy Over Time
Forecast Accuracy Among Currencies
Search for Forecast Bias
Statistical Test of Forecast Bias
Graphic Evaluation of Forecast Performance
Comparison of Forecasting Techniques

39. Chapter Review Forecasting Under Market Efficiency
Exchange Rate Volatility
Application of Exchange Rate Forecasting to the Asian Crisis
How Exchange Rate Forecasting Affects an MNC’s Value