Quantify transactions exposure Value foreign projects, to develop international operational strategies, establish prices for products ,manage
working capital. Evaluate desirability of investing in foreign equity and bond markets. To help decide whether to hedge the currency risks
International transactions are usually settled in the near future.
Exchange rate forecasts are necessary to evaluate the foreign denominated cash flows involved in international transactions. Exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment.
Four pure approaches to forecasting foreign exchange rates: (1) The fundamental approach.
(2) The technical approach.
(3) The market based approach. (4) The mixed approach.
Long term forecasting Uses fundamental macroeconomic factors to predict future exchange rates Based on formal economic models of exchange rate determination Concerned with multiyear forecast Examines economic relationships and financial data to arrive at a forecast. Short term horizons : Asset Choice Model Long term horizons : Parity Models GNP, Consumption, Trade balance, Inflation rates, Interest rates, Unemployment , Productivity indexes
Asset Choice: Examines why one currency might be preferred over others. Variables include: Relative interest rates (current and anticipated) Political/country risk Essentially, trying to identify why the demand for a currency will change
Parity Models Through these models one attempts to calculate an equilibrium exchange rate in the future. Analysis built on long standing economic theories of exchange rate determination. 1.Purchasing Power Parity Model 2.International Fisher Effect
One of the oldest exchange rate models. Assumes that exchange rates will change to offset relative prices levels between countries. Countries with relatively high rates of inflation will show currency depreciation Countries with relatively low rates of inflation will experience currency appreciation In equilibrium, the amount of depreciation (or appreciation) will be equal to the inflation differential.
Assume: Spot GBP/USD: $1.80 Forecasted UK rate of inflation (annualized) for the next 12 months: 2.5% Forecasted US rate of inflation (annualized) for the next 12 months: 1.0% PPP Spot GBP/USD Forecast 1 year change in GBP: $1.80 x .015 = 0.027. 1 year spot GBP: $1.80 - .027 = $1.773 6 month GBP: $1.80 (0.027/2) = $1.80 0.0135 = $1.7865
Assume that exchange rates will change in direct proportion to relative differences in long term interest rates. Assumes that long term interest rates capture the markets expectation for inflation. Countries with relatively high rates of long term interest rates (i.e., high inflation) will show currency depreciation. Countries with relatively low rates of long term interest rates (i.e., low inflation) will show currency appreciation. In equilibrium, the amount of depreciation (or appreciation) will be equal to the long term interest rate differential
Assume: Spot USD/JPY = 98.00 Current 1 year Japanese Government Bond rate = 0.5% Current 1 year U.S. Government Bond rate = 4.5%
Spot USD/JPY Forecast 1 year change in JPY = 98.00 x 0.04 = 3.92 1 year spot JPY = 98.00 - 3.92 = 94.08
Short term forecasting. Uses only past exchange rate data and other financial data to predict future exchange rates . Future exchange rate information is present in past trading behavior Technical analysis looks for the repetition of specific price patterns. Uses charts and price patterns to forecast future moves in spot exchange rates. Looks for price patterns that have historically signed a future move. Assume historical relationship will result in similar moves in the future.
Chartism Filter rules i. X % rules ii. Moving average Cross over rule
Chartists - Original Technical analysts Chartists - graphically record actual trading history of an exchange rate & then try to infer possible future trends To identify trends through the use of charts, practitioners must first find peaks and troughs in the price series. A peak is the highest value of the exchange rate within a specified period of time (a local maximum) A trough is the lowest value the price has taken on within the same period (a local minimum). A series of peaks and troughs establishes downtrends and up trends, respectively.
Support level - any chart formation in which price has trouble falling below a particular level. Resistance level - any chart formation in which price has trouble rising above a particular level. Support level & Resistance level define trading range. Breakout - When a trading range is broken, a sudden rise or fall in prices is expected. Chartists identifies spurious patterns Chartists dont believe in efficient financial markets.
Popular method for detecting trends in exchange rates. It is a trading strategy based on the past history of an asset price. It provides signals to an investor to buy or sell a currency.
Go long in foreign currency after the foreign currency has appreciated relative to $ by x % above its support level. Go short whenever currency falls x % below resistance level. Common x % rules - 1%,2 %.
Use moving averages of exchange rate. n-day moving average sample average of last n trading days including the current rate. A (y,z) moving average crossover rule uses averages over a short period (y days) and over a long period (z days). Go long in the foreign currency when the STMA crosses the LTMA from below. Common rules - (1,5),(1,20),(5,20).
Extensively used by forex dealers. Inherent problems in fundamental analysis like picking right exchange rate model, forecasting models fundamental variables, non- availability of all macroeconomic inputs at frequent intervals , poor measurements Forward rate not an unbiased predictor of future spot rate even in efficient market. Sufficiently large amount of trading world is using technical analysis, demands and supplies will be buffeted by these irrational traders.
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. If no forward markets exists for a particular currency , nominal interest rates are used
Refers to the use of a combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts developed.
3 dimensions to evaluate quality of a forecasts Accuracy Forecast error = actual exchange rate forecasted rate Two measures of accuracy - Mean absolute error and Root mean squared error Percentage Correct Evaluate a forecasting record by finding the % of times the forecaster was on the correct side of forward rate. It should be strictly larger than 50 % for the forecasters services to add value to decision-making process.
Profitability Technical forecasters performance is characterized by relatively small number of successful forecasts in which large profits are made & a relatively large number of incorrect predictions in which small losses are incurred. Compute profits or losses made based on forecasters advice & compare those returns to returns on alternative investments that do not require forecasts.
