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. 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.

6. 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’

7. 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.”

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

9. 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

10. British Pound Week

11. Technical Analysis

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

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

23. 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

24. 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

25. 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

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

27. 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

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. 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