Ch05-VersC.ppt

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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

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Forecasting Exchange Rates

_{Forecasting Exchange Rates}

9

ChapterChapter

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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}

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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,}

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Forecasting Techniques

• _{The numerous methods available for}

forecasting exchange rates can be categorized into four general groups:

_technical,

_fundamental,

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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}

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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}

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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

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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}

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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

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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

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Mixed Forecasting

• _{Mixed forecasting}_{refers to the use of a}

combination of forecasting techniques.

• _{The actual forecast is a weighted average of}

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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

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Forecasting Services

• _{One way to determine whether a forecasting}

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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}

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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}

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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}

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Forecast Bias

• _{If the forecast errors are consistently positive}

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Forecast Bias

• _{The following regression model can be used to}

test for forecast bias:

realized = a₀ + a₁  forecast + 

• _{If a predictor is found to be biased, the}

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Graphic Evaluation of Forecast Performance

Using the Forward Rate as a Forecast for the British Pound

R ea li ze d S p o t R at e $1.00 $1.50 $2.00 $2.50

$1.00 $1.50 $2.00 $2.50

Forecast (Forward Rate)

Perfect Forecast

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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}

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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}

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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}

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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}

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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}

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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:

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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

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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

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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

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Chapter Review

• _{Why Firms Forecast Exchange Rates}

• _{Forecasting Techniques}

– _{Technical Forecasting}

– _{Fundamental Forecasting} – _{Market-Based Forecasting} – _{Mixed Forecasting}

• _{Forecasting Services}

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Chapter Review

• _{Evaluation of Forecast Performance}

– _{Forecast Accuracy Over Time}

– _{Forecast Accuracy Among Currencies} – _{Search for Forecast Bias}

– _{Statistical Test of Forecast Bias}

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Chapter Review

• _{Forecasting Under Market Efficiency} • _{Exchange Rate Volatility}

• _{Application of Exchange Rate Forecasting to}

the Asian Crisis

• _{How Exchange Rate Forecasting Affects an}