The document discusses forecasting exchange rates. It covers why firms forecast exchange rates, common forecasting techniques including technical, fundamental, and market-based approaches, evaluating forecast performance, and forecasting under different market efficiency assumptions. Techniques include using historical exchange rate data, economic fundamentals, spot and forward rates, and combinations of approaches. Forecast errors are evaluated based on size, over time horizons, currencies, and statistical tests for bias.

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copied, scanned, or duplicated, in whole or in part, except for
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International Financial Management
10th Edition
by Jeff Madura
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© 2010 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
© 2010 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
9
Forecasting Exchange Rates
Chapter Objectives
This chapter will:

2. A. Explain how firms can benefit from forecasting
exchange rates
B. Describe the common techniques used for forecasting
C. Explain how forecasting performance can be evaluated
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copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
Why Firms Forecast Exchange Rates Hedging
decisionsShort-term investment decisionsCapital budgeting
decisionsEarnings assessmentLong-term financing decisions
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copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
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classroom use.
Forecasting TechniquesTechnical ForecastingFundamental
ForecastingMarket-Based Forecasting
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copied, scanned, or duplicated, in whole or in part, except for
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3. classroom use.
Technical ForecastingInvolves the use of historical exchange
rate data to predict future valuesLimitations 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
© 2010 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
Fundamental ForecastingBased on fundamental relationships
between economic variables and exchange ratesUse of
sensitivity analysis to account for uncertainty by considering
more than one possible outcome.Use of PPP for fundamental
analysis by forecasting inflation rate differentialsLimitations 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
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copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.

4. Market-Based ForecastingUse of the spot rate to forecast the
future spot rate.Use of the forward rate to forecast the future
spot rate
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copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
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classroom use.
Mixed ForecastingUse a a combination of forecasting
techniquesMixed forecast is then a weighted average of the
various forecasts developed
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copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
Forecast ErrorMeasurement of forecast error
Absolute forecast error as a percentage of the realized value =
(forecasted value – realized value) / realized valueForecast
error among time horizonsForecast error over time
periodsForecast errors among currenciesForecast bias
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copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
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5. Statistical Test of Forecast Bias
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Exhibit 9.6 Graphic Evaluation of Forecast Performance
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copied, scanned, or duplicated, in whole or in part, except for
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Forecasting under Market EfficiencyWeak-form efficiency:
historical and current exchange rate information is already
reflected in today’s exchange rate and is not useful for
forecasting.Semistrong-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.
© 2010 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.

6. Methods of Forecasting Exchange Rate VolatilityUse of recent
volatility levelUse of historical pattern of volatilitiesImplied
standard deviation
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