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

Forecasting Exchange Rates 9 9 Chapter South-Western/Thomson Learning © 2003

B9 - 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.

B9 - 4 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. Why Firms Forecast Exchange Rates

B9 - 5 Forecasting Techniques The numerous methods available for forecasting exchange rates can be categorized into four general groups:  technical,  fundamental,  market-based,and  mixed.

B9 - 6 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. Technical Forecasting

B9 - 7 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. Fundamental Forecasting

B9 - 8 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. Fundamental Forecasting

B9 - 9 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. Fundamental Forecasting

B 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. Market-Based Forecasting

B 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. Market-Based Forecasting

B 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.

B 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.

B 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. Forecasting Services

B 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.

B 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.

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

B 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.

B Mean Absolute Forecast Error Currency as a Percent of the Realized Value British pound4.61%5.06%4.21% Canadian dollar Japanese yen Swiss franc Evaluation of Forecast Performance

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

B Forecast Bias Using the Forward Rate as a Forecast for the British Pound Forward Rate Realized Spot Rate

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

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

B Graphic Evaluation of Forecast Performance Using the Forward Rate as a Forecast for the British Pound Realized Spot Rate Forecast (Forward Rate) Perfect Forecast Line

B 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.

B 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.

B 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.

B 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. Forecasting Under Market Efficiency

B 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. Forecasting Under Market Efficiency

B 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,

B 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.

B 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.

B 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.

B Impact of Forecasted Exchange Rates on an MNC’s Value 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 Technical Forecasting Fundamental Forecasting Market-based Forecasting Mixed Forecasting

B Why Firms Forecast Exchange Rates Forecasting Techniques ¤ Technical Forecasting ¤ Fundamental Forecasting ¤ Market-Based Forecasting ¤ Mixed Forecasting Forecasting Services ¤ Performance of Forecasting Services Chapter Review

B 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

B 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