This document discusses why companies need to forecast foreign exchange rates and various techniques for doing so. It explains that while perfectly accurate forecasts are impossible, forecasting allows companies to make informed financial decisions by deriving reasonable cash flow estimates. It then describes technical, fundamental, and market-based forecasting techniques as well as mixed approaches. Companies need forecasts for hedging decisions, short-term investments, capital budgeting, earnings assessments, and long-term financing. The most appropriate technique depends on the situation and factors being considered.
3. At the end of the chapter, students will be able
to:
understand how firms can benefit from
forecasting exchange rates.
describe the common techniques used
for forecasting.
understand how forecasting
performance can be evaluated.
Learning Outcomes
4. DO YOU THINK FORECASTING EXCHANGE RATES IS POSSIBLE FOR
COMPANIES?
Discussion
5. DO YOU THINK FORECASTING EXCHANGE RATES IS POSSIBLE FOR
COMPANIES?
In reality, it is extremely difficult to forecast exchange rates with much
accuracy. However, MNCs can still benefit from forecasting exchange rates;
doing so allows them to derive reasonable forecasts of future cash flow, which
enables them to make informed financial decisions.
Introduction
6. WHY DO YOU THINK FIRMS NEED PREDICTED / FORECAST
EXCHANGE RATES?
Discussion
7. WHY FIRMS NEED FORECAST EXCHANGE RATES?
MNCs need exchange rate forecasts for their:
• HEDGING DECISIONS - MNCs constantly face the decision of whether
to hedge future payables and receivables in foreign currencies.
• Eg Laredo Co., based in USA, plans to pay for imported clothing
imported from Mexico in 90 days. If the forecasted value of the Mexico
Peso in 90 days is sufficiently low below the 90-day forward rate, then
the MNC may decide not to hedge. Forecasting may enable the firm to
make a decision that will increase its cash flow.
8. WHY FIRMS NEED FORECAST EXCHANGE RATES?
MNCs need exchange rate forecasts for their:
• HEDGING DECISIONS - MNCs constantly face the decision of whether
to hedge future payables and receivables in foreign currencies.
• Eg We have to pay Alia USD 10000
• Spot rate USD 1 = RM 4.5
• Forward rate USD 1 = RM 4.3 (3 months)
• Forecast rate USD 1 = RM 4 (3 months)
9. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• SHORT-TERM INVESTMENT DECISIONS - Corporations sometimes
have a substantial amount of excess cash available for a short time period.
The ideal currency for deposit will (1) exhibit a high interest rate and (2)
strengthen in value over the investment period.
• Eg Lafayette Co., has excess cash and considers depositing the cash into a
British bank account. If the British pound appreciates against the dollar by
the end of the deposit period, more dollars will be received. Firm can use
forecasts of the pound exchange rate when determining whether to invest
the short-term cash in a British vs a US account.
10. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• CAPITAL BUDGETING DECISIONS - when an MNC assesses whether to
invest funds in a foreign project, the firm takes into account that the
project may periodically require the exchange of currencies. The capital
budgeting analysis can be completed only when all estimated cash flows
are measured in the MNC’s local currency.
11. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• Eg Evansville Co. wants to determine whether to establish a subsidiary in
Thailand. The earnings to be generated by the proposed subsidiary in
Thailand would need to be periodically converted into dollars to be
remitted to the US parent. The capital budgeting process requires
estimates of future dollar cash flows to be received by the US parent.
These dollar cash flows depend on the forecasted exchange rate of
Thailand’s currency (baht) against the dollar over time. Accurate forecasts
will improve the accuracy of the estimated cash flows and enhance the
MNC’s decision making.
12. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• 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.
If a strong foreign currency is expected to weaken substantially against the
parent’s currency, the parent may prefer to expedite the remittance of
subsidiary earnings before the foreign currency weaken.
13. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• LONG TERM FINANCING DECISIONS – MNCs that issue bonds to
secure long-term funds may consider denominating those bonds in foreign
currencies. They prefer that the currency borrowed depreciate over time
against the currency they are receiving from sales.
• To estimate the cost of issuing bonds denominated in a foreign currency,
forecasts of exchange rates are required.
14. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• Most forecasting is applied to currencies whose exchange rates fluctuate
continuously.
• However, some forecasts are also derived for currencies whose exchange
rates are pegged.
• MNCs recognise that a pegged exchange rate today does not necessarily
serve as a good forecast because the government might devalue the
currency in the future.
15. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• ALIA MONEY EXCHANGE vs HBC Remit (Nepal)
• MYR 1 – Rupee 28 (Friday)
• Transferred to Nepal (Nepal Rupee 10000)
• If ALIA had settled this on Friday, she needs to pay RM 357.
• MYR 1 – Rupee 25 (Monday)
• Transfer Nepal Rupee 10000
• How much would ALIA need to pay, if settle on Monday? RM 400.
• Loss on FX settlement.
16. WHY FIRMS NEED FORECAST EXCHANGE RATES?
• HOW CAN WE MINIMISE THIS RISK OF FX SETTLEMENTS?
• Make settlement payments immediately
• 30-day Forward contract with bank to settle with HBC Remit
19. FORECASTING TECHNIQUES – TECHNICAL
FORECASTING
• Involves the use of historical data to predict future values. It
includes statistical analysis and time series models.
• Speculators may find the models useful for predicting day-to-
day movements.
• However, since they typically focus on the near future and
rarely provide point/range estimates, they are of limited use to
MNCs
20. FORECASTING TECHNIQUES – TECHNICAL
FORECASTING
• Tomorrow, Kansas Co. has to pay 10 million Mexican Pesos for
supplies that is recently received from Mexico. Today, the peso has
appreciated by 3% against the dollar. Based on the analysis of
historical time series, Kansas has determined that whenever the
peso appreciated against the dollar by more than 1%, it experience
a reversal of about 60% on the following day. Forecast the
tomorrow’s exchange rate for Kansas Co. and decide whether the
Kansas Co. should pay the debts today instead of tomorrow?
22. FORECASTING TECHNIQUES – FUNDAMENTAL
FORECASTING
• Based on the fundamental relationships between economic
variables and exchange rates.
• A forecast may arise simply from a subjective assessment of the
factors that affect exchange rates.
• A forecast may be based on quantitative measurements (with the
aid of regression models and sensitivity analysis) too.
24. FORECASTING TECHNIQUES – MARKET-BASED
FORECASTING
• Involves developing forecasts from market indicators. (GEORGE SOROS)
• Based on either the spot rate or the forward rate
• Use of the spot rate
• Today’s spot rate may be use as a forecast of the spot rate that will exist on
a future date. Assume the British pound is expected to appreciate against
the dollar in the near future. This expectation will encourage speculators to
buy the pound with U.S. dollar today anticipation of its appreciation, and
these purchase can force the pound’s value up immediately
25. FORECASTING TECHNIQUES – MIXED FORECASTING
• Mixed forecasting refers to the use of a combination of
forecasting techniques.
26. FORECASTING TECHNIQUES – SUMMARY
Techniques Factors Considered Situations Forecast
Technical Forecast Recent Movement in
Peso
The peso’s value declined
below a specific threshold
level in the last few weeks
The peso’s value will
continue to fall now that
is beyond the threshold
level
Fundamental Forecast Economic Growth,
Inflation, Interest
rate
Mexico’s interest rates are
high, and inflation should
remain low
The peso’s value will rise
as U.S. investors
capitalize on the high
interest rates by investing
in Mexican securities
Market Based Forecast Spot rate, Forward
rate
The peso’s forward rate
exhibits a significant
discount, which is attributed
to Mexico’s relatively high
interest rates
Based on the forward rate,
which provides a forecast
of the future spot rate, the
peso’s value will decline.
30. Question and Answer Session
1. State TWO reasons for companies to forecast the
foreign exchange movements.
2. State TWO methods used to forecast foreign exchange
movements.
