International Finance #5

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International Financial Management 13th Edition

by Jeff Madura

9 Forecasting Exchange Rates

 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.

Chapter Objectives

Why Firms Forecast Exchange Rates (1 of 2)

Hedging decisions  Whether a firm hedges 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.

Capital budgeting decisions  When an MNC’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.

Why Firms Forecast Exchange Rates (2 of 2)

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.

Long-term financing decisions  MNCs that issue bonds to secure long-term funds may consider

denominating the bonds in foreign currencies. Summarized in Exhibit 9.1

Exhibit 9.1 Corporate Motives for Forecasting Exchange Rates

Forecasting Techniques (1 of 6)

1. Technical Forecasting 2. Fundamental Forecasting 3. Market-Based Forecasting

Forecasting Techniques (2 of 6)

Technical Forecasting  Involves the use of historical exchange rate data to

predict future values.  Limitations of technical forecasting:  Focuses on the near future.  Rarely provides point estimates or range of possible

future values.  Technical forecasting model that worked well in one

period may not work well in another.

Forecasting Techniques (3 of 6)

Fundamental Forecasting  Based on fundamental relationships between economic

variables and exchange rates  Use of sensitivity analysis for fundamental forecasting  Considers more than one possible outcome for the factors

exhibiting uncertainty.  Use of PPP 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.

 Limitations of fundamental forecasting include:  Unknown timing of the impact of some factors.  Forecasts of some factors may be difficult to obtain.  Some factors are not easily quantified.  Regression coefficients may not remain constant.

Forecasting Techniques (4 of 6)

Market-Based Forecasting  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.  Using the forward rate to forecast the future spot rate:

 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.

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Forecasting Techniques (5 of 6)

Market-Based Forecasting (Cont.)  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.

 Implications of the IFE for Forecasts  Since the forward rate captures the interest rate differential (and

therefore the expected inflation rate differential) between two countries, it should provide more accurate forecasts for currencies in high-inflation countries than the spot rate.

Forecasting Techniques (6 of 6)

Mixed Forecasting  Use a combination of forecasting techniques. (Exhibit 9.2)  Mixed forecast is then a weighted average of the various

forecasts developed. Guidelines for Implementing a Forecast  Apply forecasts consistently within the MNC  Measure impact of alternative forecasts  Consider other sources of forecasts

Exhibit 9.2 Forecasts of the Mexican Peso Drawn from Each Forecasting Technique

Forecast Error (1 of 4)

Measurement of forecast error

Forecast errors among time horizons  The potential forecast error for a particular currency depends on the

forecast horizon.

Forecast errors over time periods The forecast error for a given currency changes over time.

Forecast errors among currencies (Exhibit 9.3) The ability to forecast currency values may vary with the currency of concern.

Exhibit 9.3 How the Forecast Error Is Affected by Volatility

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.

 Statistical test of forecast bias: A conventional method of testing for a forecast bias is to apply the following regression model to historical data.

Forecast Error (2 of 4)

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Forecast Error (3 of 4)

Forecast bias (cont.)  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)

 Shifts in Forecast Bias over Time  Because the forecast bias can change over time, refining a

forecast to adjust for a forecast bias detected in the past is not a perfect solution.

Exhibit 9.4 Comparison of Forecast Techniques

Exhibit 9.5 Evaluation of Forecast Performance

Exhibit 9.6 Graphic Evaluation of Forecast Performance

Forecast Error (4 of 4)

Comparison of Forecasting Methods  An MNC can compare forecasting methods by plotting the

points relating to two methods on a graph similar to Exhibit 9.6.  The performance of the two methods can be evaluated by

comparing distances of points from the 45-degree line.  In some cases, neither forecasting method may stand out as

superior when compared graphically.

Accounting for Uncertainty Surrounding Forecasts

 Sensitivity Analysis Applied to Fundamental Forecasting  Accounts for the possible error in the forecasted value

of the factor and improve its forecasts.  Valuable because it allows the MNC to derive a variety

of forecasts based on alternative scenarios (Exhibit 9.7).

Exhibit 9.7 Illustration of Sensitivity Analysis Applied to Forecasting

Using Interval Forecasts

Methods of Forecasting Exchange Rate Volatility  Using recent levels of volatility  The volatility of historical exchange rate movements

over a recent period can be used to forecast the future.  Using historical patterns of volatilities  If there is a pattern to the changes in exchange rate

volatility over time, a series of time periods may be used to forecast volatility in the next period.

 Using implied standard deviation  Derive the exchange rate’s implied standard deviation

(ISD) from the currency option pricing model.

SUMMARY (1 of 3)

 Multinational corporations need exchange rate forecasts to make decisions on hedging payables and receivables, short- term financing and investment, capital budgeting, and long- term financing.

 The most common forecasting techniques can be classified as (1) technical, (2) fundamental, (3)market based, or (4) mixed. Each technique has limitations, and the quality of the forecasts produced varies. Yet, exchange rates are very difficult to forecast accurately, because their movements can be volatile over time.

SUMMARY (2 of 3)

 Forecasting methods can be evaluated by comparing the actual values of currencies to the values predicted by the forecasting method. To be meaningful, this comparison should be conducted over several periods. Two criteria used to evaluate performance of a forecast method are bias and accuracy. When comparing the accuracy of forecasts for two currencies, the absolute forecast error should be divided by the realized value of the currency in order to control for differences in the currencies’ relative values.

SUMMARY (3 of 3)

 MNCs specify an interval around their point estimate forecast to account for uncertainty. Such an interval can be derived from the recent exchange rate volatility, the historical time series of volatilities, and the implied standard deviation from currency option prices.

Slide Number 1
9
Why Firms Forecast Exchange Rates (1 of 2)
Why Firms Forecast Exchange Rates (2 of 2)
Exhibit 9.1 Corporate Motives for Forecasting Exchange Rates
Forecasting Techniques (1 of 6)
Forecasting Techniques (2 of 6)
Forecasting Techniques (3 of 6)
Forecasting Techniques (4 of 6)
Forecasting Techniques (5 of 6)
Forecasting Techniques (6 of 6)
Exhibit 9.2 Forecasts of the Mexican Peso Drawn from Each Forecasting Technique
Forecast Error (1 of 4)
Exhibit 9.3 How the Forecast Error Is Affected by Volatility
Forecast Error (2 of 4)
Forecast Error (3 of 4)
Exhibit 9.4 Comparison of Forecast Techniques
Exhibit 9.5 Evaluation of Forecast Performance
Exhibit 9.6 Graphic Evaluation of Forecast Performance
Forecast Error (4 of 4)
Accounting for Uncertainty Surrounding Forecasts
Exhibit 9.7 Illustration of Sensitivity Analysis Applied to Forecasting
Using Interval Forecasts
SUMMARY (1 of 3)
SUMMARY (2 of 3)
SUMMARY (3 of 3)