Students name : Kemenangan Tiba
Course number and Name : FIN 456 - International Financial Management
Instructors Name : Brittany Holloman
Date : 12/01/2024
THE RELATIONSHIP BETWEEN EXCHANGE RATES, INFLATION
AND INTEREST RATES
A. Introduction:
International trade transactions involve one country with another and make the countries
of the world more intertwined. Therefore, interaction with the outside world is something
that cannot be avoided by any country. In order to facilitate international trade transactions,
the use of money in an open economy is determined by using an agreed currency. Changes
in exchange rates can affect the development of prices for goods and services. Therefore,
exchange rate instability can affect capital flows or investment as well as international trade.
Changes in currency exchange rates also result in currency appreciation and
depreciation. Appreciation is an increase in the exchange rate of a particular country against
the value of another country's currency, while currency depreciation is a decrease in the
exchange rate of a country's currency against the value of another country's currency. And
the currencies commonly used as The comparator in currency exchange is the United States
Dollar (US Dollar) because the US Dollar is one of the currencies that is considered strong,
widely used and accepted and is the reference currency for most countries in the world.
Inflation, which is defined as a general and continuous increase in the price of goods, is
one of the macroeconomic indicators that has a close relationship with the exchange rate.
Changes in the inflation rate can affect international trade activities, so inflation is one of the
factors that can affect changes in exchange rates. Another indicator that is thought to affect
the exchange rate is the SBI (Bank Indonesia Certificate) interest rate. The ups and downs of
the exchange rate that implicate changes in the inflation rate can result in an increase and
decrease in domestic interest rates. And changes in domestic interest rates will affect the
flow of funds in a country so that it can affect the demand and supply of currency exchange
rates.
B. EXCHANGE RATE, INFLATION AND INTEREST RATE
1.
Exchange Rate:
The foreign exchange rate is the price of one unit of currency in units of another
currency. Foreign exchange rates can be established in the foreign exchange market where
different currencies are traded. So in simple terms, the exchange rate can be defined as the
price of one currency against another, or in other words, the exchange rate is the amount of
money of a certain currency that can be exchanged for one unit of currency of another
country. The exchange rate of each domestic currency against foreign currencies is also
called the foreign exchange rate. The concept of foreign exchange rate is grouped into two
types, namely the concept of Hard Currencies (strong currencies) and the concept of Soft
Currencies (weak currencies), each of which has its own characteristics. According to
Kuncoro (2016), the characteristics of currencies classified as hard currencies are: (a) the
currency is widely accepted throughout the world; (b) the market for the currency is free and
active; and (c) restrictions or in the form of relatively few barriers. While the characteristics
of currencies classified as soft currencies are: (a) the currency is not widely accepted as a
world currency; (b) it does not have a free and active forex market; and (c) the currency is
not widely accepted as a world currency (c) this currency is not easy to obtain.
Many factors can influence changes in the exchange rate of a currency. Foreign
exchange rates can change up or down when there are changes in the price of
imported/exported goods, inflation, changes in interest rates, changes in the rate of return on
investment, economic growth, and also changes in tastes. Other factors that are also thought
to affect exchange rate movements include relative income levels, government controls, and
market predictions.
Exchange rates can be divided into 2 (two), namely, nominal exchange rates and real
exchange rates. The nominal exchange rate is the relative price of two countries' currencies.
In practice, this explains how much of a domestic currency must be paid to obtain one unit
of foreign currency. On the other hand, the real exchange rate is the relative price of the two
countries' goods. In this real concept, the exchange rate is not only calculated based on the
component of nominal, but also takes into account various factors that must be considered.
These factors include domestic and foreign inflation rates, domestic and foreign demand
growth, domestic and foreign interest rates, competitiveness, country risk levels and so on.
Movements in currency exchange rates will have an impact on the value of an MNC
(Multinational Company) because exchange rates can affect the amount of cash inflows
received from exports or from subsidiaries, and affect the amount of cash outflows used to
pay for imports. Exchange rates measure the value of one unit of currency against a foreign
currency. If the economic conditions of a country change, the currency exchange rate can
change to a greater extent. Changes in currency exchange rates can take the form of
appreciation or depreciation. Appreciation is an increase in the value of a currency, while
depreciation is a decrease in the value of a currency.
a decrease in the value of a currency.
There are several types of exchange rate transactions, including:
a.
Spot transactions:
Spot transactions are purchases of foreign exchange with delivery and payment between
banks taking place after the second business day. The spot exchange rate is the nominal
exchange rate on that day, or the value of the foreign currency against the domestic
currency at the time of the transaction.
b.
Outright forward transactions:
A forward transaction requires the delivery at a future date of a specified amount of a
currency for a specified amount of another currency, the exchange rate of which is fixed
at the time of the agreement. The forward rate is the rate set now for delivery/settlement
at a later date.
c.
Swap Transactions:
A swap transaction is the simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates with the same counterparty in the interbank
market.
d.
Currency rate derivatives:
Currency rate derivative transactions have been discussed in depth in the previous
chapter of this book.
2.
Inflation:
Mankiw (2000) defines inflation as a continuous increase in the price of goods.
According to Sukirno (2015) Inflation is a continuous increase in the price of goods,
inflation can be divided into 3 namely demand pull inflation, cost push inflation, and
imported inflation. Meanwhile, according to Rahardja (2014), Inflation is an increase in the
prices of goods that are general and continuous. From this definition, there are three
components that must be met in order to be said to be inflation, namely price increases,
general, and continuous.
a.
Price increase:
The price of a commodity is said to increase if it becomes higher than the price of the
previous period. The comparison of price levels can be done at different intervals of time, be
it a week, a month, a quarter, or a year. Price comparisons can also be made based on
seasonal benchmarks, for example, in the lean season, the price of rice can reach Rp 15,000
per kilogram because the price of grain has also increased. But in the harvest season, the
price of rice can be cheaper as the price of grain has decreased. So it can be said, in the lean
season, there is always an increase in the price of rice.
b.
General:
An increase in the price of a commodity cannot be said to be inflationary if the increase does
not cause prices to rise in general. For example, when the government increases the price of
fuel (Bahan Bakar Minyak), it will usually be followed by an increase in the price of other
commodities. This is because an increase in fuel prices can cause transportation operating
costs to rise. An increase in fuel prices will also cause the selling price of industrial products
to increase due to rising operational costs. Even an increase in fuel prices can also invite
laborers to demand an increase in wages to maintain their purchasing power.
c.
Ongoing:
A general increase in prices will not give rise to inflation if it occurs only briefly. Therefore,
the calculation of inflation is done in a minimum monthly time span. Because after a month
it will be seen whether the price increase is general and continuous.
For example, if the government announces that inflation this year is 8%, it means
that the accumulated inflation is 8% per year. Quarterly inflation averages 2% (8%:4), while
monthly inflation is about 0.67%.
(8%: 12).
In macroeconomics, there are several indicators that can be used to determine the
inflation rate of a country during a certain period. Among these indicators include:
a.
Consumer price index:
The consumer price index (CPI) is an index number that shows the price level of goods and
services that consumers have to buy in a certain period. The CPI figure is obtained by
calculating the prices of the main goods and services consumed by the public in a certain
period. Each price of goods and services is weighted based on its level of importance, goods
and services that are considered the most important are given the greatest weight.
b.
Wholesale price index:
Unlike the CPI, the Wholesale Price Index (IHPB) looks at inflation from the producer side.
It is therefore also referred to as the producer price index. IHPB shows the price level
received by producers at various levels of production.
c.
Implicit price index (GDP Deflator):
To get the most representative picture of inflation, economists use the implicit price index
(GDP deflator), abbreviated as IHI. Similar to the previous two indicators, inflation
calculation based on IHI is done by calculating the change in the index number. The basic
principle of calculating inflation based on the GDP deflator is by comparing the growth rate
of the national economy with real growth. The difference between the two is the inflation
rate.
Notes: Gross Domestic Product (GDP).
Some of the social problems (social costs) that arise from high inflation (>10% per year)
include:
a.
Declining levels of people's welfare.
The level of community welfare can be measured by the level of purchasing power of the
income earned. Inflation causes the purchasing power of income to decrease, especially for
people with small and fixed (small) incomes.
b.
Worse distribution of wealth.
The adverse impact of inflation on welfare can be avoided if income growth is higher than
the inflation rate. But if this condition cannot be realized, then inflation will lead to a
worsening of the distribution of wealth (people's income).
c.
Disruption of economic stability.
Chronic inflation leads to the expectation that prices of goods and services will continue to
rise. For consumers, this expectation encourages them to purchase more goods and services
than they should, in order to save on consumption expenditure. For producers, the
expectation of inflation encourages them to delay sales, resulting in a reduced supply of
goods and services. As a result, excess demand increases sharply and accelerates the rate of
inflation, which will worsen economic conditions.
3.
Interest Rate:
Interest is the return on borrowed money, while the interest rate is the percentage
calculated on the principal paid as a return over a certain period. Interest rates are also called
the price of borrowing. Interest is a measure of the price of resources used by the debtor that
is paid to the creditor. In general, when interest rates are low, more funds flow, resulting in
increased economic growth. Similarly, when the interest rate is high, less funds flow and this
will result in low economic growth.
Interest rate stability is an important factor in promoting financial market stability so that
the ability of financial markets to channel funds from those who have productive investment
opportunities can run smoothly and economic activity also remains stable. Therefore, the
central bank of a country has the task of maintaining interest rate stability in order to create a
more stable financial market. In Indonesia, Bank Indonesia Certificates (SBI) are securities
issued by Bank Indonesia and are one of the components used by the government to control
the money supply. The SBI interest rate is a reference for the rate of return earned by
investors when investing risk-free.
Changes in relative interest rates affect investment in foreign securities, which will affect
the demand and supply of foreign exchange. This in turn affects fluctuations in the exchange
rate. The perfect relationship between relative interest rates and exchange rates between two
countries is explained by the international fisher effect (IFE) theory. Berlianta (2005) argues
that the International Fisher Effect theory shows that the movement of the value of one
country's currency compared to another country is caused by the difference in nominal
interest rates that exist in the two countries. The implication of IFE is that a person cannot
enjoy higher profits by investing in a country that has a high nominal interest rate because
the value of the currency of the high interest rate country will depreciate by the difference in
nominal interest with a country with a lower nominal interest rate.
Edmister (1986) argues that there are three terms related to interest rates, namely stated
rate, annual percentage rate, and yield.
a.
Stated rate, which is the interest rate for one period multiplied by the principal amount
of the loan to calculate interest expense.
b.
Annual percentage rate, which is an interest rate annualized by adjusting the stated
rate for the number of periods per year and the principal amount actually borrowed.
c.
Yield, which is the interest rate equivalent to one financial contract and meets three
conditions: (1) the total amount actually borrowed; (2) at the beginning of the year;
and (3) repaid at the end of the year with interest.
While the function of interest rates in the economy according to Puspopranoto (2004),
among others:
a.
Helping investment flow to support economic growth.
b.
Distribute the available credit amount.
c.
Balancing the amount of money in circulation with the demand for money in a
country.
d.
It is a government policy tool regarding savings and investment.
Interest rates are determined in the financial system, but are also influenced by the real
system. That is, the savings and investment decisions made by households, businesses,
governments and other parties that affect the flow of funds. Interest rates can also be divided
into nominal interest rates and real interest rates. The real interest rate is the nominal interest
rate after correction for price changes (inflation).
The way to determine the interest rate in the financial system can use the Liquidity
preference approach and the Loanable funds approach. Both are partial equilibrium theories
because they do not take into account changes in the real sector, but produce the same
interest rate. The liquidity preference approach views that interest rates are determined by
the amount of money demanded and offered in the financial system. In contrast, the loanable
funds approach views the financial system as an area in which loanable funds are traded in
primary and secondary markets and the interest rate is the result of supply and demand for
loanable funds. Meanwhile, the structure of the interest rate is determined by the factors of
term, tax characteristics, degree of arrears risk and ease of marketing.
C. THE RELATIONSHIP BETWEEN EXCHANGE RATES, INFLATION, AND
INTEREST RATES:
1.
Correlation of Inflation Rate with Exchange Rate:
Inflation is closely related to currency exchange rates. Changes in the inflation rate can
affect the demand for currency in a country, which can also affect international trade
patterns. Changes in the inflation rate can affect international trade activities. If a country’s
inflation increases, the demand for its currency decreases as its exports also decrease due to
higher prices. This is followed by the tendency of domestic consumers and companies to
increase imports. These two attitudes will certainly encourage high inflation in a country’s
currency. The inflation rate of one country is different from another, so the pattern of
international trade and exchange rates will also change accordingly.
The theory that explains the relationship between exchange rates and inflation rates
between two countries is the purchasing power parity (PPP) theory. The purchasing power
parity theory states that the equilibrium exchange rate will adjust to the magnitude of the
difference in inflation rates between the two countries. This will result in consumers’
purchasing power to buy domestic products will be equal to their purchasing power to buy
foreign products. The purchasing power parity theory of exchange rates argues that
exchange rate movements are mainly caused by differences in inflation rates between
countries.
a.
Purchasing Power Parity (PPP):
The relative form of PPP considers the possibility of imperfect markets such as
transportation costs, import duties, and quotas. Due to market imperfections, the prices of
different products in different countries are not always the same when measured in the same
currency. However, if transportation costs, and other trade restrictions do not change, then
the rate of change in the prices of goods will be approximately the same when measured in
the same currency. If two countries produce products that are substitutes for each other, the
demand for those products will change when there is a difference in inflation rates. As the
PPP theory states that the exchange rate is not fixed but will change to maintain purchasing
power parity.
The relative form of PPP can be used to estimate how exchange rates will change as a
result of differences in inflation rates between countries. The PPP theory not only provides
an explanation of how the inflation rate between two countries can affect the exchange rate,
but also provides information that can be used to predict the exchange rate. The weakness in
testing the PPP theory is that the results differ depending on the base period used. The base
period chosen should reflect the equilibrium position since the evaluation of the next period
will be compared with the base period. One of the main reasons for eliminating fixed
exchange rates is that it is difficult to identify a feasible exchange rate equilibrium.
Purchasing power parity can be tested by assessing the real exchange rate between two
currencies over time. The real exchange rate is the actual exchange rate after adjusting for
the impact of inflation on the two countries.
b.
Interest Rate Parity (IRP):
Interest rate parity (IRP) is a theory that states that the forward rate premium (or
discount) should equal the difference in interest rates between the two countries. IRP
indicates the interest rate that should result from the currency exchange process. An example
of IRP application is given below:
1)
A US investor converts US$ 1,000,000 into Swiss French money (spot rate SF
I.5000/$). The result of this conversion is: SF 1,500,000.
2)
The money is invested for three months in a Swiss Bank deposit with an interest rate
of 5% per annum. At maturity, it earns interest
+ principal: SF 1,500,000 x (1+0.05/4) = SF 1,518,750.
3)
At maturity he converts the money back to US$ (forward rate SF 1.4800/$). The result
of this conversion was US$ 1,026,182.
Note that the IRP is the interest rate by depositing US$ 1,000,000 at an interest rate of
2.00% per 3 months (or 8.00% per annum) resulting in principal+interest: US$ 1,020,000.
The implication of this transaction is that the forward and spot rate comparisons are the
same as the SF interest rate and the $ interest rate.
c.
Covered Interest Arbitrage (CIA):
Covered interest arbitrage indicates the opportunity for profit due to the arbitrage
process due to the imbalance of the interest rate (IRP) with the offered rate.
The following is an example of a CIA application:
Arbitrage:
1)
The US investor converts US$1,000,000 into Japanese Yen (spot rate ¥110.00/$). The result
of this conversion is:
¥110.000.000.
2)
This money is invested for six months in a Japanese bank deposit with an interest rate of 5%
per annum. At maturity, it earns interest
+ principal: ¥110,000,000. x (1x0.05/2) = ¥112,750,000.
3)
At maturity he converts his money back to US$ (forward rate ¥108.00/$). The result of this
conversion is: US$ 1,043,981.
Deposits:
If the deposit with Bank of America is 6.00% per annum, then if US$1,000,000 is
deposited at maturity, the principal + interest is earned: $ 1.000.000 x (1+0.06/2) = $
1.030.000.
Note: the cost of funds if deposited money is US$ 1,043,981-US$ 1,030,000 = $ 13,981.
this value is the profit obtained if doing the arbitrage process.
2.
Correlation of Interest Rate with Exchange Rate:
The phenomenon of the relationship between the exchange rate and the interest rate uses
the Fisher equation approach (Fisher Effect). The effect on the exchange rate is very
different, depending on changes in real interest rates, and changes in inflation expectations.
Suppose, that the domestic real interest rate rises, while inflation expectations are
unchanged or constant, then the nominal interest rate rises. In this case, it is reasonable to
assume that the expected appreciation of the rupiah will remain unchanged because inflation
expectations are unchanged, so the expected return on foreign currency RET1RP deposits
will remain unchanged for any given exchange rate.
More clearly this relationship can be seen in the following figure. This graph shows that
the RET$ remains unchanged and the RETRP shifts to the right, thus it can be concluded
that when the domestic real interest rate rises, the domestic currency appreciates.
Description:
An increase in expected earnings on rupiah savings, iRp, shifts RET1Rp to RET2Rp and
the exchange rate from E1 to E2.
If the domestic nominal interest rate rises due to rising inflation expectations, the result
will be different from what the chart has shown. An increase in domestic inflation
expectation leads to a decrease in Rupiah appreciation expectation (higher USD
appreciation). This increase is slightly larger than the increase in the domestic interest rate of
iRp.
Thus, at any given exchange rate, the expected return on USD savings rises above the
expected return on Rupiah savings. As seen in the figure below, the RET$ line shifts to the
right more than the RETRp line, so the exchange rate falls. Therefore, when the domestic
interest rate rises due to rising inflation expectations, the value of the domestic currency
depreciates.
At any given exchange rate, the expected return on USD deposits rises above the
expected return on rupiah deposits. As seen in figure 1.1, the RET$ line shifts to the right
more than the RETRp line, so the exchange rate falls. Therefore, when the domestic interest
rate rises due to rising inflation expectations, the domestic currency depreciates.
Rising domestic inflation expectations lead to a fall in expected rupiah appreciation
which is greater than that generated by a rise in the domestic interest rate, expected earnings
on USD savings rise more than expected earnings in rupiah. The RET$ shifts to the right
more than the NETRp, and the equilibrium exchange rate falls from E1 to E2.
3.
Correlation of Foreign Exchange Fluctuations with Inflation and Interest Rates:
Based on the Fisher Effect theory (i = r + I), the formula to calculate the real interest rate
can be derived as follows:
Rr(x) = Rn(x) - [I(x) + Pr(x) + F(x)]
Description:
Rr (x) = Real interest rate in country x
Rn (x) = Nominal interest rate in countryI (x) Inflation rate in country x
Pr (x) = Risk premium in country x
F (x) = Premium of other factors in country x
Based on this formula, it can be explained as follows:
a.
If in the initial condition the following data is obtained: interest rate = 70%, inflation =
50%, Pr = 15% and F = 0%, then:
Rr = 70% - (50% + 15% + 0%) = 5%
b.
If interest rates fall to 40%, inflation falls to 15%, and Pr is 15%, then:
Rr = 40% - (15% + 15% + 0%) = 10%
As a result, the value of the currency will rise or appreciate.
c.
Conversely, if interest rate = 50%, inflation rate = 50% (remains high), and Pr = 15%,
then:
Rr = 50% - (50% + 15% + 0%) = -15% (negative)
As a result, the value of the currency will fall or depreciate.
So it can be concluded: (1) fluctuations or movements in exchange rates have a positive
relationship with real interest rates, meaning that if real interest rates in country x rise, then
the exchange rate of currency x will rise and vice versa; (2) differences in nominal interest
rates between two countries or currencies do not necessarily reflect differences in real
interest rates.
D. Material Summary:
The exchange rate is the amount of money from a particular currency that can be
exchanged for one unit of another country's currency. The exchange rate of each domestic
currency against foreign currencies is also called the exchange rate (foreign exchange rate)
which is grouped into two types, namely the concept of Hard Currencies (strong currencies)
and the concept of Soft Currencies (weak currencies). There are several types of exchange
rate transactions, including: spot transactions, forward outright transactions, swap
transactions, and currency rate derivatives.
Inflation is a general and continuous increase in the price of goods. Some indicators that
can be used to determine the inflation rate of a country during one period are: Consumer
price index, Wholesale price index, and implicit price index (GDP Deflator). Social
problems that may arise due to inflation include: a decrease in the welfare of the of the
people, increasingly worsening distribution wealth distribution, and disruption of economic
stability. Interest is a measure of the price of resources used by debtors that are paid to
creditors. While the interest rate is a percentage calculated from the principal of the debt that
is paid as a return in a certain period. The functions of interest rates in the economy include:
(a) help the flow of investment to support economic growth; (b) distribute the amount of
credit available; (c) balance the amount of money in circulation with the demand for money
in a country; and (d) is a government policy tool regarding savings and investment. Changes
in rate inflation can affect international trade activities. If a country's inflation increases, the
demand for its currency will decline as its exports also decline due to higher prices. This is
followed by the tendency of consumers and companies in domestic to increase imports. The
phenomenon of the relationship between exchange rates and interest rates is the Fisher
equation approach (Fisher Effect). The effect on the exchange rate will be different,
depending on the change in the interest rate.
real, and changes in inflation expectations.
TASKS AND EVALUATION:
1.
Explain what is meant by exchange rates, inflation and interest rates!
2.
Name some indicators that can be used to determine the inflation rate!
3.
Name some functions of interest rates in the economy!
4.
How are hard currencies different from soft currencies!
5.
Explain how the interest rate correlates with the exchange rate!
EXCHANGE RATE FORECASTING
A. Definition Of Forecasting:
Forecasting is basically a guess or estimate about the occurrence of an event or event in
the future. Forecasting is an important tool in efficient and effective planning. Forecasting is
the process of estimating what will happen in the future, such as: the exchange rate of the
rupiah against the dollar one year in the future.
One of the most important indicators in a country's economy is the exchange rate.
Exchange rates have broad implications, both in the context of the domestic and
international economy, given that almost all countries in the world conduct international
transactions. Foreign exchange, which is often referred to as Forex, is basically foreign
currencies. A very important issue to consider in foreign exchange issues is the exchange
rate. All countries cannot meet all their consumption needs from their own production,
although there are also some commodities whose results exceed domestic needs so that they
can be exported. Therefore, a nation must require foreign currency in its transactions
International. The need for foreign currency, which is then called forex, will cause a
complicated problem, namely determining how much the exchange rate of one country's
currency is against another country's currency. Forex forecasting (Kuncoro and Inayah,
2003) is a very important strategy for the success of multinational companies. Because most
of the operations of a multinational company are affected by changes in exchange rates. The
decision to hedge future forex payables, short-term financing decisions, short-term
investment decisions, capital budgeting decisions, long-term financing decisions and profit
valuation, are operational activities in multinational companies where all these decisions are
affected by changes in exchange rates (Madura, 2004).
Forecasting is an effort to estimate what will happen in the future based on past data,
based on scientific and qualitative methods that are carried out systematically. So far, a lot
of forecasting has been done intuitively using statistical methods such as smoothing, Box-
Jenkins, econometrics, regression and so on. The selection of the method depends on various
aspects, namely time aspects, data patterns, the type of system model observed, the desired
level of forecast accuracy and so on. Exchange rate is a comparison of the exchange rate of a
country's currency with a foreign country's currency or a comparison of exchange rates
between countries. The exchange rate is also one of the most important macroeconomic
variables, as currency exchange rates can maintain economic stability in a region or country.
Foreign exchange activities or abbreviated with forex are often carried out by everyone in
the world, such as traveling to other countries, business people and the general public who
trade dollars to get the maximum profit possible. Another example is the result of export and
import activities, market needs and bank institutions, definitely doing currency exchange
activities. Information like this is very helpful for business people to make decisions in
investing and trading their money in order to gain large profits.
This need for information makes forecasting one of the ways that can help business
people make wiser decisions to trade their dollars.
B. The Need For Currency Rate Forecasting:
The projection of currency exchange rates plays a very important role in the
establishment of operating policies. Some of these policies include:
1.
Risk fencing policy (hedging decision).
2.
Short-term funding policy.
3.
Short-term investment policy.
4.
Capital budgeting policy.
5.
Long-term funding policy.
6.
Revenue estimation
Some MNC decisions are influenced by exchange rate projections. Financial managers
must understand how to forecast exchange rates so that they make decisions that maximize
the value of their MNC. Virtually all MNC operations can be affected by changes in
exchange rates. Here are some corporate functions that require exchange rate forecasting:
1.
Hedging decisions, (hedging):
Hedging decisions can be determined after obtaining foreign exchange forecasting results.
Hedging as a financial strategy will ensure that the value of foreign exchange used to pay
(outflow) or the amount of foreign exchange to be received (inflow) in the future is not
affected by changes in foreign exchange fluctuations.
2.
Short-term Financing Decisions,
When large corporations borrow foreign exchange, the foreign exchange loan/debt is used
for hedging purposes but it is also clear that a significant amount of the borrowed foreign
exchange is used for domestic purposes.
3.
Short-Term Investment Decisions,
Companies sometimes have significant amounts of excess cash that can be invested on a
short-term basis. Large deposits can be invested in several currencies.
4.
Capital Budgeting Decisions,
Forecasting future cash flows used in the capital budgeting process will depend on future
exchange rates. This dependency may occur because:
(1)
incoming or outgoing foreign exchange cash flows, requiring conversion into the
home country's currency and/or
(2)
the effect of future exchange rates on the demand for the company's products.
5.
Long-term Financing Decision:
Companies that issue bonds to raise long-term funds may want to denominate the bonds in
forex.
6.
Profit Valuation.
MNC earnings are reported by consolidating and translating into the currency that dominates
the parent company's financial statements.
C. Conditions For Generating Currency Rate Forecasts
There are several criteria that need to be met in order to produce accurate forecasts.
However, not all of these criteria must be met, depending on the situation and conditions of
the forecast. These criteria are:
1.
There are superior forecasting models that have exclusive use.
2.
Consistent access to information.
3.
There is a small deviation from forecasting.
4.
Proper prediction of government intervention in the foreign exchange market.
D. Currency Rate Forecasting Techniques
1.
Technical Forecasting:
This forecasting uses historical exchange rate data and sometimes this forecasting is
done simply by observing the data without using statistical calculations. However, it is not
uncommon for statistical calculations to be included in forecasting. In addition, there are
also some time series models that are used to test moving averages so that forecasters can
make interpretations based on the test results. These technical forecasting models have
proven their usefulness in various foreign exchange markets. However, a model that is
suitable for one market may not be suitable for another market, and although there is a wide
variety of technical forecasting models, the test results prove that there is no single model
that is highly profitable and consistent.
2.
Fundamental Forecasting:
This forecasting is based on the fundamental relationship between economic variables
and exchange rates. By assigning certain values to the value variables, the company can
develop projections of future exchange rates.
Forecasting is done by providing a subjective assessment of the degree to which
movements in general economic variables will affect the exchange rate. That forecasting the
value of the pound is only influenced by two factors:
a.
Inflation in the US is relative to inflation in the UK.
b.
Income growth in the US relative to income growth in the UK.
Limitations forecasting Fundamentals, forecasting Fundamental forecasting has four
limitations, namely:
a.
The uncertainty of the effect of a factor at a given time.
b.
Forecasting is required for factors that have a direct influence on the exchange rate.
c.
Not all relevant factors were included in the model.
d.
The changing sensitivity of currency movements over time is because nothing is
consistent in the market over time other than change itself, so the coefficient values in
the regression model will always change.
These weaknesses prove that no matter how sophisticated a forecasting model is, there is
no guarantee that it will always be consistent in its forecasting results. There is always a
probability of error.
3.
Forecasting Method (Market-based):
This method uses market indicators that are usually based on (1) spot rates or (2)
forward rates. The reason why spot rates are used as the basis for market-based forecasting
can be explained with the following example. If it is assumed that the pound sterling will
appreciate against the dollar, this may encourage speculators to buy pounds with dollars,
thereby accelerating the appreciation, and vice versa. The reason why forward rates can also
be used as a basis for market-based forecasting can be explained as follows. For example,
the price of 1.4 dollars is equal to 1 pound and in the next 30 days it is expected to be 1.45
dollars.
4.
Mixed Forecasting:
Mixed forecasting can be done when each forecasting technique is of equal superiority.
The way to do this mixed forecast is to weigh the projection results of each technique with a
high total balance. And in addition, it can measure uncertainty by measuring the range of
forecasting results of the techniques used. Prediction or forecasting is an effort to estimate
what will happen in the future based on past data, based on scientific and qualitative
methods carried out systematically.
Along with the development of increasingly advanced technology, time series data
forecasting has been widely developed. According to Box et al (1994) in Makridakis et al
(1999), a time series is a group of observation values obtained at different times with the
same interval and the data rows are assumed to be independent of each other. One of the
widely used forecasting methods is Autoregressive Integrated Moving Average (ARIMA).
ARIMA is a method that produces forecasts based on the synthesis of historical data patterns
(Arsyad, 1995). ARIMA is often called the Box-Jenkins method. ARIMA is very good in
accuracy for short-term forecasting, while for long-term forecasting the accuracy of
forecasting is not good. Usually it will tend to be flat or constant for a long enough period
(Ekananda, 2014). In general, the ARIMA (Box-Jenkins) model is formulated with the
following notation (Sugiarto and Harijono, 2000); ARIMA (p,d,q) in this case p is the
order/degree of Autoregressive (AR), d indicates the order/degree of Differencing, q
indicates the order/degree of Moving Average (MA).
The ARIMA model is a model that completely ignores independent variables in
forecasting. ARIMA uses past and present values of the dependent variable to produce
accurate short-term forecasts, but for long-term forecasting the forecasting accuracy is not
good. The goal of ARIMA is to determine a good statistical relationship between the
variable being forecasted and the historical values of that variable so that forecasting can be
done with the model. ARIMA is used for a variable (univariate) time series. In this study,
the ARIMA model will be used as an analytical tool to predict the rupiah exchange rate
against the US dollar in 2017. To make it easier to calculate the ARIMA model, researchers
use the eviews7 application.
The Autoregressive Integrated Moving Average (ARIMA) model is a model that
completely ignores independent variables in making forecasts. ARIMA uses past and present
values of the dependent variable to produce accurate short-term forecasts. ARIMA is
suitable when the observations of the time series are statistically related to each other
(dependent). The purpose of the ARIMA model is to determine a good statistical
relationship between the variable being forecasted and the historical value of the variable so
that forecasting can be done with the model. The ARIMA model itself only uses a variable
(univariate) time series. It is important to note that most time series are non-stationary and
that the AR and MA aspects of the ARIMA model are only concerned with stationary time
series. Stationarity means that there is no growth or decline in the data. The data should be
roughly horizontal along the time axis. In other words, the fluctuations in the data are around
a constant average value, independent of time and the variance of the fluctuations remains
essentially constant over time.
A non-stationary time series must be converted into stationary data by differencing.
What is meant by differencing is calculating the change or difference in the observation
value. The difference value obtained is checked again whether it is stationary or not. If it is
not stationary then differencing is done again. If the variance is not stationary, then a
logarithmic transformation is performed. In general, the ARIMA (Box- Jenkins) model is
formulated with the following notation (Sugiarto and Harijono, 2000); ARIMA (p,d,q) in
this case p is the order/degree of Autoregressive (AR), d indicates the order/degree of
Differencing, q indicates the order/degree of Moving Average (MA).
The Autoregressive (AR) model is a form of regression but does not relate the
independent variables, but rather relates previous values at various time lags. So an
Autoregressive model will express a forecast as a function of the previous values of a
particular time series (Makridakis, 1999).
In practice, it is often found that economic data is non-stationary so it needs to be
modified, by differencing, to produce stationary data. Differencing is done by subtracting the
value in a period from the value in the previous period. In general, data in the business world
will become stationary after the first differencing. If after the first differentiation the data is
still not stationary, it is necessary to do the next differentiation. The data used as input to the
ARIMA model is the transformed data that has become stationary, not the original data. The
number of times the differencing process is performed is denoted by d. For example, the
original data is not yet stationary, then the first differencing is performed and produces
stationary data.
a.
Anomalies in Forex:
Besides following a rhythm as projected by technical analysis, forex behavior often
moves atypically. These are called anomalies because they are inconsistent with the efficient
market hypothesis. Examples of anomalies that are often cited are the January effect and
speculative bubbles. The January effect can be seen in the case of the US dollar. When
observing the behavior of the US dollar during the 1980s, it turns out that the dollar
appreciated against a basket of forex every January, except in 1986 and 1987 (Trucker et.al
1991: pp.52-53). More interestingly, the performance of the dollar in January can be used to
forecast the performance of the dollar within the year during 1980-1989, except for 1985.
This means that if the dollar strengthened (weakened) in January then the following months
of the year also tended to strengthen (weaken). This phenomenon may be due to the fact that
many companies inhibit their plan Forex at month January and implement it immediately
that year. If the dollar is expected to strengthen that year, companies will start buying
dollars. And if it is expected to depreciate, then companies will rush to sell dollars. Thus
expectations tend to result in appreciation or depreciation and become self-fulfilling
prophecies.
prophecy)
b.
Forecasting Strategy:
In practice, there is no one forecasting technique that is completely accurate in
forecasting the future movement of forex rates. Therefore, many companies, managers and
traders in the forex market use a combination of various techniques in forecasting forex
rates. This method is called mixed forecasting. This method is used by giving weight to each
technique with a total value of 100. Techniques that have more significant values are given
more weight.
Long-term forex forecasting can be done in various ways including computer time series
analysis (called ARIMA= Autoregressive Integrated Moving Average) or econometric
analysis with multiple regression and fundamental analysis.
E. Material Summary:
Multinational companies need exchange rate forecasting to avoid risks, make decisions
on debt and credit hedging, short-term funding and investment, capital budgeting, long-term
funding and revenue estimation. To achieve all these, accurate exchange rate forecasting is
required.
The most commonly used forecasting techniques are grouped as follows: (1) technical
forecasting, (2) fundamental, (3) market-based methods, and (4) mixed forecasting. Each
method has limitations and the quality of the forecast results varies. However, due to the
high variation in exchange rates, it is not surprising that forecasting is not always accurate.
Tasks And Evaluation:
1.
Explain, What are the objectives and benefits of Exchange Rate forecasting for
companies?
2.
Explain, what factors must be identified for exchange rate forecasting to be accurate?
3.
Based on the observation of the Rupiah exchange rate against the US Dollar, the
regression coefficients are as follows: b₀ = 0.04, b₁ = 0.7 and b₂ = 2.0. It is predicted
that the difference in inflation rate (INF) is 7% and the difference in income (PDT) is
5%. What is the forecast value of the future Rupiah?
4.
The one-year Australian dollar forward rate is $0.80, while the spot rate is $0.75.
Calculate the approximate percentage change in the Australian dollar?
