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 CHAPTER 9 Forecasting Exchange Rates © 2000 South-Western College Publishing 1

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.

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.

Forecasting Techniques Technical forecasting involves the use of historical data to predict future values. It includes statistical analysis and time series models, and is similar to the technical forecasting of stock prices. Speculators may find technical forecasting models useful for predicting day-to-day movements. For MNCs however, their use may be limited, since they typically focus on the near future, and rarely provide point or range estimates.

Forecasting Techniques Fundamental forecasting is based on the fundamental relationships between economic variables and exchange rates. A forecast may arise simply from a subjective assessment, or it can be based on quantitative measurements. For example, in a regression model, the coefficients are estimated using historical data. Forecasts can then be made using the appropriate variable values. If the values are uncertain, sensitivity analysis can be applied.

Forecasting Techniques Known relationships like the PPP can also be used. However, problems may arise because: ¤ the timing of the impact of inflation fluctuations on trade behavior is not known for sure, ¤ the relative prices may be measured inaccurately, ¤ trade barriers may disrupt the trade patterns that should emerge according to PPP, ¤ other factors that affect exchange rates exist.

Forecasting Techniques In general, fundamental forecasting is limited by : ¤ the uncertain timing of the impact of factors, ¤ the need for forecasts for factors with instantaneous impact, ¤ the possibility that other relevant factors may be omitted from the model, ¤ changes in the sensitivity of currency movements to each factor over time.

Forecasting Techniques Market-based forecasting involves developing forecasts from market indicators. Usually, either the spot rate or the forward rate is used, since they should reflect the market expectation of the future rates. For long-term forecasting, the quoted interest rates on risk-free instruments can be used to determine what the forward rates should be under conditions of interest rate parity. Note that the use of forward rates has been criticized because they are driven by another market force - the interest rate differential.

Forecasting Techniques Mixed forecasting refers to the use of a combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts developed.

Forecasting Services The corporate need to forecast currency values has prompted some consulting firms and banks to offer forecasting services. Advice on international cash management, assessment of exposure to exchange rate risk and hedging may be provided too. 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.

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 will also want to compare its various forecasting methods. One such measure is the absolute forecast error as a percentage of the realized value: | forecasted value - realized value | realized value MNCs may have more confidence in their forecasts when they know the mean error for their past forecasts.

Evaluation of Forecast Performance Note that the degree of forecast accuracy may vary for different currencies. For example, the value of a less volatile currency is likely to be forecasted more accurately. If the errors are consistently positive or negative over time, then there is a bias in the forecasting procedure. The following regression model can test for bias: actual_rate = a0 + a1 ´ forecast + m If a bias is found, the estimated a0 and a1 values can be used to correct the systematic error.

Graphic Evaluation of Forecast Performance Perfect forecast line x z Realized Value Predicted Value Region of downward bias Region of upward bias

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. If the market is strong-form efficient, then all the relevant public and private information is already reflected in the current exchange rates.

Forecasting Exchange Rate Volatility MNCs also forecast exchange rate volatility. This enables them to develop best-case and worst-case scenarios along with their point estimate forecasts. Several methods are possible: ¤ Use the volatility of historical exchange rate movements as a forecast. ¤ Use a time series of the volatility patterns in previous periods. ¤ Derive the exchange rate’s implied standard deviation from the currency option pricing model.

Application of Exchange Rate Forecasting to the Asian Crisis Before the crisis, the spot rate served as a reasonable predictor, while the use of fundamental factors was not as suitable, because of intervention by the central banks. But even after the crisis began, it is unlikely that the degree of depreciations could have been accurately predicted by the usual models. The two key factors leading to the sharp decline in the Asian currency values are: the large amount of foreign investment, and the fear of a massive selloff of the currencies.

Impact of Forecasted Exchange Rates on an MNC’s Value Technical forecasting Fundamental forecasting Market-based forecasting Mixed forecasting 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 the end of period t k = the weighted average cost of capital of the U.S. parent

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

Chapter Review Evaluation of Forecast Performance Forecast Accuracy Over Time Forecast Accuracy Among Currencies Forecast Bias Graphic Evaluation of Forecast Performance Forecasting Under Market Efficiency Forecasting Exchange Rate Volatility Application of Exchange Rate Forecasting to the Asian Crisis How Exchange Rate Forecasting Affects an MNC’s Value