here we are trying to explain how firms can benefit from forecasting exchange rate, to describe common technique that used to forecast, how to evaluate forecasting performance

1. Forecasting Exchange Rates
By: Hesniati, SE., MM.
9Chapter

2. Part III
Exchange Rate Risk Management
Information on existing and
anticipated economic conditions of
various countries and on historical
exchange rate movements
Information on existing and
anticipated
cash flows in
each currency
at each subsidiary
Measuring exposure to
exchange rate
fluctuations
Forecasting exchange
rates
Managing exposure to
exchange rate
fluctuations

3. Chapter Objectives
• To explain how firms can benefit from forecasting exchange rates;
• To describe the common techniques used for forecasting; and
• To explain how forecasting performance can be evaluated.

4. Why Firms Forecast
Exchange Rates
• MNCs need exchange rate forecasts for their:
• hedging decisions,
• short-term financing decisions,
• short-term investment decisions,
• capital budgeting decisions,
• long-term financing decisions, and
• earnings assessment.

5. Forecasting Techniques
• The numerous methods available for forecasting exchange rates can
be categorized into four general groups:
 technical,
 fundamental,
 market-based,and
 mixed.

6. Technical Forecasting
• 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.

7. Technical Forecasting

8. Fundamental Forecasting
• Fundamental forecasting is 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.

9. Fundamental Forecasting
• Known relationships like the PPP can be used for the regression
models. However, problems may arise. In the case of PPP:
• the timing of the impact of inflation on trade behavior is not known for sure,
• prices may be measured inaccurately,
• trade barriers may disrupt the trade patterns that should emerge, and
• other influential factors may exist.

10. Fundamental Forecasting
• In general, fundamental forecasting is limited by :
• the uncertain timing of the impact of the factors,
• the need for forecasts for factors with instantaneous impact,
• the possibility that other relevant factors may be omitted from the model,
and
• changes in the sensitivity of currency movements to each factor over time.

11. Market-Based Forecasting
• Market-based forecasting 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.

12. Market-Based Forecasting
• Since forward contracts have low trading volumes and are not widely
quoted, the interest rates on risk-free instruments can be used to
determine what the forward rates should be according to IRP for
long-term forecasting.

13. Mixed Forecasting
• Mixed forecasting refers to the use of a combination of forecasting
techniques.
• The actual forecast is a weighted average of the various forecasts
developed.

14. Forecasting Services
• The corporate need to forecast currency values has prompted some
consulting firms and investment banks to offer forecasting services.
• Advice on hedging and international cash management, and
assessment of the firm’s exposure to exchange rate risk, may be
provided too.

15. Forecasting Services
• One way to determine whether a forecasting service is valuable is to
compare the accuracy of its forecasts with the accuracy of publicly
available and free forecasts.

16. Evaluation of Forecast Performance
• An MNC that forecasts exchange rates should monitor its
performance over time to determine whether its forecasting
procedure is satisfactory.
• The MNC may also want to compare the various forecasting
methods.

17. Evaluation of Forecast Performance
• One measure of forecast performance is the absolute forecast error
as a percentage of the realized value:
| forecasted value – realized value |
realized value
• Over time, MNCs are likely to have more confidence in their
forecasts when they know the mean error for their past forecasts.

18. Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
1975 1980 1985 1990 1995 2000
AbsoluteForecastError($)

19. Evaluation of Forecast Performance
• The ability to forecast currency values may vary with the currency of
concern.
• In particular, the value of a less volatile currency is likely to be
forecasted more accurately.

20. Evaluation of Forecast Performance
Mean Absolute Forecast Error
Currency as a Percent of the Realized Value
1974-1998 1974-1984 1985-1998
British pound 4.61 % 5.06 % 4.21 %
Canadian dollar 1.73 1.70 1.75
Japanese yen 5.60 5.22 5.93
Swiss franc 5.69 5.81 5.58

21. Forecast Bias
• If the forecast errors are consistently positive or negative over time,
then there is a bias in the forecasting procedure.

22. Forecast Bias
Using the Forward Rate as a Forecast for the British Pound
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
$2.60
1975 1980 1985 1990 1995 2000
Forward Rate
Realized
Spot Rate

23. Forecast Bias
• The following regression model can be used to test for forecast bias:
realized = a0 + a1 × forecast + µ
• If a predictor is found to be biased, the estimated a0 and a1 values can
be used to correct the systematic error.

24. Graphic Evaluation of Forecast Performance
Perfect
forecast line
x z
x
zRealizedValue
Predicted Value
Region of downward bias
(underestimating)
Region of
upward bias
(overestimating)

25. Graphic Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
RealizedSpotRate
$1.00
$1.50
$2.00
$2.50
$1.00 $1.50 $2.00 $2.50
Forecast (Forward Rate)
Perfect
Forecast
Line

26. Graphic Evaluation
of Forecast Performance
• If the points appear to be scattered evenly on both sides of the
perfect forecast line, then the forecasts are said to be unbiased.
• Note that a more thorough assessment can be conducted by
separating the entire period into subperiods.

27. Comparison of
Forecasting Techniques
• The different forecasting techniques can be evaluated
• graphically - by comparing the distances from the perfect forecast line, or
• statistically - by computing the mean of the absolute forecast errors, and
then using a t-test or a nonparametric test to determine whether there is a
significant difference in the accuracy of the forecasting techniques.

28. Forecasting Under Market Efficiency
• If the foreign exchange market is weak-form efficient, then the
current exchange rates already reflect historical information. So,
technical analysis would not be useful.
• If the market is semistrong-form efficient, then all the relevant public
information is already reflected in the current exchange rates.

29. Forecasting Under Market Efficiency
• If the market is strong-form efficient, then all the relevant public and
private information is already reflected in the current exchange
rates.
• Foreign exchange markets are generally found to be at least
semistrong-form efficient.

30. Forecasting Under Market Efficiency
• Nevertheless, MNCs may still find forecasting worthwhile, since their
goal is not to earn speculative profits but to use exchange rate
forecasts to implement policies.
• In particular, MNCs may need to determine the range of possible
exchange rates in order to assess the degree to which their operating
performance could be affected.

31. Exchange Rate Volatility
• MNCs also forecast exchange rate volatility. This enables them to
specify a range (confidence interval) and develop best-case and
worst-case scenarios along with their point estimate forecasts.
• Popular methods for forecasting volatility include:
 the use of recent exchange rate volatility,

32. Exchange Rate Volatility
 the use of a historical time series of volatilities (there may be a pattern in
how the exchange rate volatility changes over time), and
 the derivation of the exchange rate’s implied standard deviation from the
currency option pricing model.

33. Application of Exchange Rate Forecasting
to the Asian Crisis
• Before the crisis, the spot rate served as a reasonable predictor,
because the central banks were maintaining a somewhat stable
value for their respective currencies.
• But even after the crisis began, it is unlikely that the degree of
depreciation could have been accurately predicted by the usual
models.

34. Application of Exchange Rate Forecasting
to the Asian Crisis
• The large amount of foreign investment and the fear of a massive
selloff of the currencies played key roles in the sharp decline of the
Asian currency values.
• However, these two factors cannot be easily incorporated into a
fundamental forecasting model in a manner that will precisely
identify the timing and magnitude of currency depreciation.

35. Impact of Forecasted Exchange Rates
on an MNC’s Value
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ERECFE
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E (CFj,t ) = expected cash flows in currency
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E (ERj,t ) = expected exchange rate at
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Technical Forecasting
Fundamental Forecasting
Market-based Forecasting
Mixed Forecasting

36. Chapter Review
• Why Firms Forecast Exchange Rates
• Forecasting Techniques
• Technical Forecasting
• Fundamental Forecasting
• Market-Based Forecasting
• Mixed Forecasting
• Forecasting Services
• Performance of Forecasting Services

37. Chapter Review
• Evaluation of Forecast Performance
• Forecast Accuracy Over Time
• Forecast Accuracy Among Currencies
• Search for Forecast Bias
• Statistical Test of Forecast Bias
• Graphic Evaluation of Forecast Performance
• Comparison of Forecasting Techniques

38. Chapter Review
• Forecasting Under Market Efficiency
• Exchange Rate Volatility
• Application of Exchange Rate Forecasting to the Asian Crisis
• How Exchange Rate Forecasting Affects an MNC’s Value