Topic 4 Forecasting Exchange Rate

Transcription

1 Topic 4 Forecasting Exchange Rate

2 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.

3 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.

4 Forecasting Under Market Efficiency If the market is semistrong-form efficient, then, - all the relevant public information is already reflected in the current exchange rates.

5 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 in developed economies.

6 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.

7 Forecasting Floating Exchange Rates Fundamental analysis Technical analysis Market-based forecasting Mixed 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 - PPP & ER 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 - Economic Growth & ER (China) Tradable goods Manufacturing industry 1980s:slow compared with developed countries - RMB devaluation Since mid-1990s: much faster compared with developed countries - RMB revaluation

11 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.

12 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.

13 Technical analysis (1)

14 Technical analysis (2)

15 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.

16 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.

17 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.

18 Mixed Forecasting Forecast Factors Situation Considered Technical Recent movement The peso s value declined Forecast in Peso in the last few weeks below a specific threshold level Fundamental Economic growth, Mexico s interest rates Forecast inflation, interest rate are high, and inflation should remain low Market-based spot rate, forward rate The peso s forward rate exhibits Forecast a significant discount, which is attributed to Mexico s relatively high interest rates.

19 Consider some factors and ER International merger waves and US$ rate Equity flows and Euro/$ rate Capital flight from developing countries to US vs US $ rate Dollarization and US$ rate Deteriorating economic fundamentals and currency crises. BOP deficit and ER in developed countries.

20 BOP Deficits & US$ ER Regression analysis - If BOP deficit accounts for 4%-5% of GDP - serious imbalance Developing countries: period (25 BOP deficit scenarios) If BOP deficit lasts for 4 years and has accounted for 5% of GDP, then ER trend will change.

21 BOP Deficits & US$ Rate 2003: US BOP deficit $530 billion, - 5.3% of GDP 2004: US BOP deficit $668 billion, - 5.7% of GDP

22 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.

23 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.

24 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.

25 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.

26 The Distinction between an Accurate Forecast and a Profitable Forecast Suppose that the J /$ spot rate is currently 110/$. A 90-day forecast puts the change rate at 102/$;the 90-day forward rate is 109/$. One decision rule: buy the yen forward. If we buy $1million worth of yen forward and the actual rate turns out to be J 108/$, Then this decision will yield a profit of $9259[(109,000, ,000,000)/108].

27 The Distinction between an Accurate Forecast and a Profitable Forecast In contrast, if the forecasted value of the yen had been 111/$,then The decision rule :sell yen forward If sold forward $1million worth of yen, the loss should be $9259. [(108,000, ,000,000)/108] Thus an accurate forecast, off by less than 3%, leads to a loss; and a less accurate forecast, off by almost 6%, leads to a profitable decision.

28 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.

29 Evaluation of Forecast Performance Currency Mean Absolute Forecast Error as a Percent of the Realized Value British pound 4.61 % 5.06 % 4.21 % Canadian dollar Japanese yen Swiss franc

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

31 Forecast Bias Using the Forward Rate as a Forecast for the British Pound $2.60 $2.40 Forward Rate $2.20 $2.00 $1.80 $1.60 $1.40 $1.20 Realized Spot Rate $

32 Absolute Forecast Error ($) Evaluation of Forecast Performance Using the Forward Rate as a Forecast for the British Pound

33 Forecast Bias The following regression model can be used to test for forecast bias: realized = a 0 + a 1 forecast + m If a predictor is found to be biased, the estimated a 0 and a 1 values can be used to correct the systematic error.

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

35 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.

36 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.

37 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.

38 Exchange Rate Volatility Popular methods for forecasting volatility include: - the use of recent 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

39 Exchange Rate Volatility the derivation of the exchange rate s implied standard deviation from the currency option pricing model

40 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.

41 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.

42 Impact of Forecasted Exchange Rates on an MNC s Value Value = n j 1 t=1 m E Fundamental Forecasting Technical Forecasting Market-based Forecasting Mixed Forecasting CF E ER j, t 1 k E (CF j,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent t j, t

43 Forecasting Fixed Exchange Rates Assessing the BOP outlook: Measuring the magnitude of required adjustment Timing of adjustment Nature of adjustment Devaluation or revaluation