Part III

Exchange Rate Risk Management

Information on existing
and anticipated
economic conditions of
various countries and
on historical exchange
rate movements

Forecasting
exchange
rates

Information on existing
and anticipated
cash flows in
each currency
at each subsidiary

Managing
exposure to
exchange rate
fluctuations

Measuring
exposure to
exchange rate
fluctuations

Chapter

9
Forecasting Exchange Rates

See c9.xls for spreadsheets to

accompany this chapter.

South-Western/Thomson Learning 2003

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.

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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,
long-term financing decisions, and
earnings assessment.
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Forecasting Techniques
The numerous methods available for
forecasting exchange rates can be
categorized into four general groups:
technical,
fundamental,
market-based,and
mixed.

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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

near future and rarely provide point/range
estimates, they are of limited use to MNCs.
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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

measurements (with the aid of regression
models and sensitivity analysis) too.
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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
other influential factors may exist.
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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 to each factor over time.

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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 expectation of the future exchange
rate.
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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 should be according to IRP for longterm forecasting.

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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 the various forecasts developed.

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Online Application
Visit http://www.yardeni.com for reviews of
international political and economic
events and their presumed global impact.
The site also presents economic and
political analyses of major economies.

Country outlooks and exchange rate

forecasts can also be found at
http://biz.yahoo.com/ifc/.
C9 - 13

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
firms exposure to exchange rate risk, may
be provided too.
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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.

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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

various forecasting methods.

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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

confidence in their forecasts when they
know the mean error for their past forecasts.

C9 - 17

Evaluation of Forecast Performance

Absolute Forecast Error ($)

Using the Forward Rate as a Forecast for the British Pound

0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
1975

1980

1985

1990

1995

2000
C9 - 18

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.

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Evaluation of Forecast Performance

Currency

Mean Absolute Forecast Error

as a Percent of the Realized Value
1974-1998 1974-1984 1985-1998

British pound
Canadian dollar
Japanese yen
Swiss franc

4.61 %
1.73
5.60
5.69

5.06 %
1.70
5.22
5.81

4.21 %
1.75
5.93
5.58

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

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Forecast Bias
Using the Forward Rate as a Forecast for the British Pound
$2.60

Forward Rate

$2.40
$2.20
$2.00
$1.80
$1.60
$1.40
$1.20
$1.00
1975

Realized
Spot Rate
1980

1985

1990

1995

2000
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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

estimated a0 and a1 values can be used to
correct the systematic error.

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Graphic Evaluation of Forecast Performance

Realized Value

z
Region of
downward bias
(underestimating)

Perfect
forecast
line

Region of
upward bias
(overestimating)

x
x

Predicted Value

z
C9 - 24

Graphic Evaluation of Forecast Performance

Using the Forward Rate as a Forecast for the British Pound

Realized Spot Rate

$2.50

Perfect
Forecast
Line

$2.00

$1.50

$1.00
$1.00

$1.50

$2.00

$2.50

Forecast (Forward Rate)

C9 - 25

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.

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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
absolute forecast errors, and then using a ttest or a nonparametric test to determine
whether there is a significant difference in
the accuracy of the forecasting techniques.
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Forecasting Under Market Efficiency

If the foreign exchange market is weakform 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.
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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 to be at least semistrong-form
efficient.

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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

the range of possible exchange rates in
order to assess the degree to which their
operating performance could be affected.
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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:
the use of recent exchange rate volatility,
C9 - 31

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 rates
implied standard deviation from the
currency option pricing model.

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Online Application
Various foreign exchange resources,
including exchange rate volatility based
on historical exchange rate movements,
can be found at http://www.oanda.com and
http://pacific.commerce.ubc.ca/xr/.

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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 models.

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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 depreciation.
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Impact of Forecasted Exchange Rates

on an MNCs Value
Technical Forecasting
Fundamental Forecasting
Market-based Forecasting
Mixed Forecasting

E CF E ER

Value =
t =1

j 1

j, t

1 k

j, t

E (CFj,t )
=
expected cash flows in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t )
=
expected exchange rate at
which currency j can be converted to dollars at

C9 - 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

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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
Graphic Evaluation of Forecast
Performance
Comparison of Forecasting Techniques
C9 - 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 MNCs Value

C9 - 39