Chapter 9 - Forecasting Exchange Rates Flashcards
Chapter objectives:
Explain why firms forecast exchange rates.
Describe the common techniques used for forecasting.
Explain how forecasting performance can be evaluated.
Explain how to account for the uncertainty surrounding forecasts.
Why Firms Forecast Exchange Rates
Hedging decisions:
–> Whether a firm hedges (future payables and receivables in foreign currencies) may be determined by its forecasts of foreign currency values.
Short-term investment decisions
–> Corporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies. The ideal currency for deposits will exhibit a high interest rate and strength in value over the investment period
Capital budgeting decisions
–> When an M N C’s parent assesses whether to invest funds in a foreign project, the firm takes into account that the project may periodically require the exchange of currencies. Accurate forecasts of currency values will improve the accuracy of the estimated cash flows, thereby enhancing the MNC’s decision making.
Why Firms Forecast Exchange Rates–> Earnings assessment
The parent’s decision about whether a foreign subsidiary should reinvest earnings in a foreign country or remit earnings back to the parent may be influenced by exchange rate forecasts.
If a strong foreign currency is expected to weaken substantially against the MNC’s home country currency, then the parent may prefer to expedite the remittance of subsidiary earnings before the foreign currency weakens.
Exchange rate forecasts are also useful for forecasting an MNC’s earnings. When earnings of an MNC are reported, subsidiary earnings are consolidated and translated into the parent firm’s home country currency.
Forecasting Techniques
*Most forecasting is applied to currencies whose exchange rates fluctuate continuously, which is the focus of this chapter.
*However, some forecasts are derived for currencies whose exchange rates are pegged. MNCs recognize that the value of a currency with a pegged exchange rate could change because the government might devalue the currency in the future.
- Technical Forecasting
- Fundamental Forecasting
- Market-Based Forecasting
- Mixed Forecasting
Why Firms Forecast Exchange Rates–> Long-term financing decisions
M N Cs that issue bonds to secure long-term funds may consider denominating the bonds in foreign currencies.
They may periodically need to convert their cash flows into the currency denominating the bonds to make interest or principal payments on the bonds.
To estimate the cost of issuing bonds denominated in a foreign currency, they require forecasts of exchange rates.
Technical Forecasting
–>Involves the use of historical exchange rate data to predict future values.
–> There may be a trend of successive daily exchange rate adjustments in the same direction, which could lead to a continuation of that trend.
–> Alternatively, there may be some technical indication that a correction in the exchange rate is likely, which would result in a forecast that the exchange rate will reverse its direction.
–> Technical forecasting is sometimes cited as the main technique used by investors who speculate in the foreign exchange market, especially when their investment is for a very short time period.
Limitations of technical forecasting:
–>. Useful for very short-term periods (e.g. one day).
–>. It may work well in one particular period but may not work well in another period.
–>. If the foreign exchange market is weak-form efficient (future prices are random and not influenced by past events), then historical and current exchange rate information is not useful for forecasting exchange rate because today’s exchange rates already reflect this information. In other word, technical analysis would not be able to improve upon today’s exchange rates when forecasting those rates in the near future.
Fundamental Forecasting
Based on fundamental relationships between economic variables and exchange rates
Use of P P P for fundamental forecasting
–> While the inflation differential by itself is not sufficient to accurately forecast exchange rate movements, it should be included in any fundamental forecasting model.
Fundamental Forecasting with a Lagged Impact
–> Fundamental forecasting sometimes has to account for a lagged (delayed) impact, in which changes in variables in an earlier period spill over to affect exchange rate movements in a later period.
Instantaneous Influences in Fundamental Forecasting:
–>. Some independent variables may have an instantaneous influence on exchange rates.
–>. The values of independent variables may not be known at the time when the M N C wants to forecast the exchange rate, forecasts for these independent variables must be used.
Forecasting with a Comprehensive Model:
–>. Comprehensive model might include many more factors than are described here, the application would still be similar. A large time-series database would be necessary to warrant any confidence in the relationships detected by such a model.
–>. Change in a currency’s spot rate is influenced by the following factors:
ef = f (ΔI N F, ΔI N T, ΔINC, ΔGC, ΔEXP )
where
ef = percentage change in the spot rate
ΔINF = change in the differential between U. S. inflation and the foreign country’s inflation
ΔINT = change in the differential between the U.S. interest rate and the foreign country’s interest rate
ΔINC = change in the differential between the U.S. income level and the foreign country’s income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates
Limitations of fundamental forecasting include:
The precise timing of the impact of some factors on a currency’s value is not known. The full impact of factors on exchange rates potentially might not occur until two, three, or four quarters later. The regression model would need to be adjusted accordingly.
Some factors have an immediate impact on exchange rates, which means that an MNC needs to forecast values for these factors before it can forecast exchange rate movements. In this case, the accuracy of the exchange rate forecast is influenced by the MNC’s ability to forecast values of these factors. Sometimes an MNC’s exchange rate forecasts may be inaccurate.
Some factors that deserve consideration in the fundamental forecasting process cannot be easily quantified. For example, if large Australian exporting firms experience an unanticipated labor strike that slows the production of their goods, this will reduce the availability of Australian goods for U.S. consumers and, in turn, reduce U.S. demand for Australian dollars. Such an event, which would put downward pressure on the Australian dollar’s value, usually is not incorporated into a forecasting model.
Coefficients derived from the regression analysis may not remain constant over time. If a country imposes new trade barriers (or eliminates existing barriers), the impact of the inflation differential or any other factors on international trade (and therefore on exchange rates) could
Market-Based Forecasting:
Market-Based Forecasting: The process of developing forecasts from market indicators, known as market-based forecasting, is usually based on either the spot rate or the forward rate.
–>Using the spot rate: Today’s spot rate may be used as a forecast of the spot rate that will exist on a future date.
–>If the foreign exchange market is weak-form efficient, the spot rate quoted today should reflect all available information.
–>Thus, the current value of a currency should reflect the expectations about the currency’s value in the near future.
E (ef)=0
Of course, MNCs realize that the currency’s value will not remain constant. Even so, they might use today’s spot rate as their best guess of the spot rate at a future point in time.
Using the forward rate to forecast the future spot rate: A forward rate quoted for a specific date in the future is commonly used as the forecasted spot rate on that future date.
F= S(1+p)
E(e)= p
E(e)= F/S - 1
where:
E(e) = expected percentage change in the exchange rate
p = percentage by which the forward rate (F) exceeds the spot rate (S)
Rationale for using the forward rate should serve as a reasonable forecast for the future spot rate because otherwise speculators would trade forward contracts (or futures contracts) to capitalize on the difference between the forward rate and the expected future spot rate.
Market-Based Forecasting (Continued)
Long-Term Forecasting with Forward Rates:
–> Long-term exchange rate forecasts can be derived from long-term forward rates. Like any method of forecasting exchange rates, the forward rate is typically more accurate when forecasting exchange rates for short-term horizons than for long-term horizons.
Mixed Forecasting:
Mixed Forecasting: Because no single forecasting technique has been found to be consistently superior to the others, some MNCs prefer to use a combination of forecasting techniques. This approach is referred to as mixed forecasting.
–> Use a combination of forecasting techniques. (Exhibit 9.2)
–> Mixed forecast is then a weighted average of the various forecasts developed.
Consider other sources of forecasts
–> Forecasting exchange rates is subject to considerable error, M N Cs may complement their own forecasts with forecasts from outside sources, such as a bank or a securities firm that provides forecasting services.
Assessment of Forecast Performance - Measurement of forecast error
Absolute Forecast error as a % of the realized Value = (Forecasted Value - Realized Value) /Realized Value
Forecast errors among time horizons
–> The potential forecast error for a particular currency depends on the forecast horizon.
Forecast errors among currencies (Exhibit 9.3)
–> The ability to forecast currency values may vary with the currency of concern.
Comparing Forecast Errors among Forecast Techniques (Exhibit 9.4)
–> An M N C may compare the forecast error produced by two or more techniques used to derive forecasted exchange rates for a particular currency so that it can decide which technique to use in the future.
Exhibit 9.3 How the Forecast Error Is Affected by Volatility
The exhibit demonstrates how forecast errors are generally smaller for less volatile currencies
Exhibit 9.4 Comparison of Forecast Techniques
When a forecast error is measured as the forecasted value minus the realized value, negative errors indicate underestimating whereas positive errors indicate overestimating.
The mean absolute forecast error when using Model 1 is 0.04, so this model’s forecasts are off by 0.04 on average. Model 1 is not perfectly accurate but does a better job than Model 2, which had a mean absolute forecast error of 0.07. Overall, predictions with Model 1 are (on average) closer to the realized value.
Assessment of Forecast Performance - Graphic Evaluation of Forecast Bias
Forecast bias can be examined with the use of a graph that compares forecasted values with the realized values for various time periods. (Exhibits 9.4, 9.5 & 9.6)
Exhibit 9.6 Graphic Evaluation of Forecast Performance
*All points above the 45-degree line reflect underestimation, whereas all points below the 45-degree line reflect overestimation.
*If points appear to be scattered evenly on both sides of the -degree line, then the forecasts are said to be unbiased because they are not consistently above or below the realized values.
*Because most of the points in Exhibit 9.6 are below the perfect forecast line, the forecasts have typically overestimated the actual spot rate three months later.
