Chapter 9: Forecasting Exchange Rates Flashcards
Why do firms forecast foreign exchange rates?
Hedge decisions: payable/receivable
Short term investment decisions
Capital budgeting decisions
Earnings assessments: reinvest or remit to home, forecast earning
Long term financing
Technical forecasting
Technical: Use of historical exchange rate data to predict future values
* Main technique by investors who speculate in foreign exchange market
Limits:
- good for short term - not long
-can work in one period but not the next
-Weak form efficient: all info already reflected in spot rates
Fundamental forecasting
Based on fundamental relationships b/w economic variables (inflation, income, interest) and exchange rates
How is the PPP used in Fundamental Forecasting
PPP theory specifies the fundamental relationship b/w two countries inflation differential and exchange rate
○ Currency of higher inflation country will depreciate by inflation differential
○ If holds: % change in currency value (ef) = inflation rate home (Ih) - foreign inflation rate (If)
EXAMPLE: PPP for fundamental forecasting
AUS inflation 6% , US inflation 1%, spot rate 0.50
what is new spot rate
Ef = (1.01 / 1.06) -1 = -4.7% (change in AUS rate)
New spot rate = 0.50 ( 1 - 0.047 ) = 0.4765 new spot rate (0.50 old)
Example: Fundamental forecast lagged
Bo = 1
B1 = 0.9
INF t-1 - 3%
What is foreign exchnge rate change
B1 = 0.9 means 1% inflation diff = 0.9 change in currency
Ef = 0 + 0.9(3%) = 2.7% change
Changes from earlier period impact later period
Impact of inflation differential may be lagged
Limitation of fundamental forecast
- Unknown timing of the impact of some factors
- Forecasts of some factors difficult to obtain
- Some factors not easily quantified
- Regression coefficients may vary
New trade barriers
What is market based forecasting
use of a market-determined exchange rate (such as the spot rate or forward rate) to forecast the spot rate in the future
Use the spot rate: weak form efficient
E (ef) = 0
Use the foward rate:
F = S(1+p)
E(ef) = p = (F/S) - 1
What is market based forecasting
use of a market-determined exchange rate (such as the spot rate or forward rate) to forecast the spot rate in the future
Use the spot rate: weak form efficient
E (ef) = 0
Use the foward rate:
F = S(1+p)
E(ef) = p = (F/S) - 1
Summary of Forecasting Techniques
Technical:
Considers - movement of foreign currency
Fundamental:
Considers - economic growth, inflation, interest rates
Market based
Considers - spot + forward rate
Forecast errors
Time horizon: longer = more error
Currencies: more volatile = more error
What is forecast bias?
When a forecast error is measured as the forecasted value minus the realized value, negative errors indicate underestimating, while positive errors indicate overestimating
Above 45 line = under estimate
Below = over est
Even scattered = unbiased
How do you measure forecast error?
By taking the absolute difference between the forecasted and actual exchange rate.
Market Efficiencies
Weak-form efficiency: historical and current exchange rate information is already reflected in today’s exchange rate and is not useful for forecasting.
Semi-strong-form efficiency: all relevant public information is already reflected in today’s exchange rate.
Strong-form efficiency: all relevant public and private information is already reflected in today’s exchange rate.
What is the purpose of sensitivity analysis in forecasting?
A: To explore how changes in key assumptions or variables affect exchange rate forecasts and to account for possible forecast error
Possible inflation diff * prob of occur = expected rate movement if occurs
