Reasons Firms Forecast Exchange Rates
-Hedging decision (whether or not to hedge) - inc. CFs
-ST investment decision - inc. CFs
-Capital budgeting decision - inc. CFs
-Earnings assessment - inc. CFs
-LT financing decision - dec. cost of capital
Forecast Exchange Rates: ST Investment
-when deciding where to invest excess cash available for ST
-large deposits can be established in several currencies
-the ideal currency for deposits will have a high IR and strengthen over the investment period
Forecast Exchange Rates: Capital Budgeting
-when deciding whether to invest funds in a foreign project
-firm takes into account the project may require the exchange of currencies
-exchanging foreign currency back to dollars or exchange rate may affect demand for the foreign sub's products
Forecast Exchange Rates: Earnings Assessment
-whether or not to reinvest sub's earnings in foreign country or remit back to the parent's currency
-also useful for forecasting MNCs earnings--sub's earnings have to be translated to parent currency to consolidate
Forecast Exchange Rates: LT Financing
-corp's may consider denominating bonds they're issuing in a foreign currency
-they would prefer the currency depreciate over time against the currency they're receiving sales in
Forecast Exchange Rates: Pegged Currencies
-most forecasting is done for currencies that fluctuate a lot, but some is done for pegged currencies
-a pegged rate isn't a good forecast for the future bc it could be taken off at any time
Forecasting Techniques
1. Technical
2. Fundamental
3. Market Based
4. Mixed
-no single technique has been found to be consistently superior to the others
Forecasting Techniques: Technical
-involves the use of historical exchange rate data to predict future values
-a trend of higher mean daily adj's may indicate future appr.
-some technical indicators may point to a correction
Forecasting Techniques: Technical - Limitations
-typically focuses on the near future (like 1 day), which isn't very helpful for developing corporate policies or for firms who need to forecast in the distant future
-rarely provides point estimates or a range of possible future values
-a particular mode
Forecasting Techniques: Fundamental
-based on fundamental relationships between economic variables and exchange rates
-given current values of inflation, IRs, income level, gov. controls, expectations of future exchange rates--and their historical impact on a currency's value, corp's can de
Forecasting Techniques: Fundamental - Sensitivity Analysis
-considers more than one possible outcome for the factors exhibiting uncertainty (factors that have an immediate effect on exchange rates and so must be forecasted)
-sometimes the factors have a lagged impact and real numbers can be used as inputs
-278 bo
Forecasting Techniques: Fundamental - PPP
-use PPP formula and then plug answer (Ef) into:
-expected spot rate at end of year = existing spot rate(1+Ef)
-the inflation differential alone is not sufficient to accurately forecast exchange rate movements but can be included in your model
Forecasting Techniques: Fundamental - Limitations
-timing of the impact of some factors is not known
-some factors have an immediate effect and can be difficult to forecast accurately even if you could know how much the factor influences the exchange rates
-some factors can't be easily quantified (labor
Forecasting Techniques: Market Based
-developing forecasts from market indicators
-usually based on the spot rate or forward rate
Forecasting Techniques: Market Based - Spot Rate
-the current value of the currency should reflect the expectation of its value in the very near future
-when the spot rate is used as the forecast #, the implication is the currency will not appreciate or depreciate
-expectations of appreciation would cau
Forecasting Techniques: Market Based - Forward Rate
-a forward rate quoted for a specific date in the future is commonly used as the forecasted spot rate on that date
-the premium paid for a forward contract represents the % by which the forward rate exceeds the spot rate
-Expected % Change in Exchange Rat
Forecasting Techniques: Market Based - Forward Rate Use Rationale
-the forward rate should serve as a reasonable forecast for the future spot rate bc otherwise speculators would use forward contracts to capitalize on the difference
-speculation helps push the forward rate to the level that reflects the general expectati
Forecasting Techniques: Market Based - Forward Rate (LT)
-forward rates are normally available for periods of 2-5+ yrs, but bid/ask spread is wide bc of limited trading volume
-the quoted IRs on risk-free instruments of various countries can be used to determine what the forward rates would be under conditions
Forecasting Techniques: Market Based - IFE & IRP
-since the forward rate captures the nominal IR (includes expected inflation rate) between 2 countries, it should provide more accurate forecasts for currencies in high inflation countries than the spot rate
-if a firm is forecasting ST-a day or week-the
Forecasting Techniques: Mixed
-various forecasts for a particular currency are developed using several forecasting techniques
-techniques used are assigned weights totaling 100% according to their reliability
-the actual forecast is a weighted average of the various forecasts develope
Forecasting Error: Measurement--Absolute Forecast Error as a % of the Realized Value Formula
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Forecasting Error: Time Horizons
-the likelihood of error increases as the time horizon increases
Forecasting Error: Time Periods
-the forecast error for a given currency changes over time
-it may be greater in a period of volatility from things like political/economic instability
Forecasting Error: Currencies
-the ability to forecast currency values may vary among currencies
-firms want currencies with low forecast errors, which usually goes with low volatility
Forecast Bias
-negative errors over time indicate underestimating; positive errors-overestimating
-if the errors are consistently positive/negative over time, then a bias in the forecasting procedure does exist
Forecast Bias: Statistical Test
-if the forward rate is a biased predictor of the future spot rate, this implies a systematic forecast error
-if the forward rate is unbiased, it fully reflects all available info about the future spot rate
Comparison of Forecasting Methods
-291 book example
Forecasting under Marketing Efficiency
-efficiency of the foreign exchange market has implications for forecasting
-weak-form, semistrong-form, or strong-form
-foreign exchange markets are generally found to be at least semistrong-form, MNC forecasts may still be worthwhile
-MNCs' goal is to i
Weak-Form Efficient
-historical and current exchange rate information is not useful for forecasting exchange rate movements bc today's exchange rates reflect all this information
-technical analysis would not be capable of improving forecasts
Semistrong-Form Efficient
-all relevant public info is already reflected in today's exchange rates
-if today's rates fully reflect historical trends but not other public info, the market is weak-form, not semistrong-form
Strong-Form Efficient
-all relevant public and private info is already reflected in today's exchange rates
-cannot be tested bc private info is not available
Interval Forecasts
-MNCs may specify an interval around their point estimate forecast, especially for more volatile currencies
-to forecast exchange rate volatility you start by determining the relevant period
-292 book example
Methods of Forecasting Exchange Rate Volatility
-recent exchange rate volatility
-historical time series of volatilities
-the implied standard deviation derived from currency option prices
Exchange Rate Volatility: Historical Patterns
-not necessarily an accurate predictor since historical volatility can change over time
-may be useful to the extent that there is a pattern to the changes in volatility
-various economic/political factors can cause exchange rate volatility to change abru
Exchange Rate Volatility: Implied Standard Deviation
-can be derived from the currency option pricing model
-volatility is measured by standard deviation