INTERNATIONAL FINANCE Lecture 22

Review Forecasting Techniques  Technical,  Fundamental,  Market-based  Mixed.

Forecasting Exchange Rates & Measuring Exposure to Exchange Rate Fluctuations Lecture 22

Forecast Error Regardless of which method is used or which service is hired to forecast exchange rates, it is important to recognize that forecasted exchange rates are rarely perfect. The potential forecast error is larger for currencies that are more volatile because the spot rates of these currencies could easily wander far from any forecasted value in the future.

Forecasting Services The corporate need to forecast currency values has prompted some consulting firms and investment/commercial banks to offer forecasting services. One way to determine the value of a forecasting service is to compare the accuracy of its forecasts to that 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. One popular measure, the absolute forecast error as a percentage of the realized value, is defined as: | forecasted value – realized value | realized value

Evaluation of Forecast Performance MNCs are likely to have more confidence in their forecasts as they measure their forecast error over time. Forecast accuracy varies among currencies. A more stable currency can usually be more accurately predicted. If the forecast errors are consistently positive or negative over time, then there is a bias in the forecasting procedure.

Forecast Bias The following regression model can be used to test for forecast bias: realized value = a 0 + a 1  F t – 1 + 

Forecast Bias in Different Subperiods for the British Pound

Comparison of Forecasting Methods The different forecasting methods can be evaluated ¤ graphically – by visually comparing the deviations from the perfect forecast line, or ¤ statistically – by computing the forecast errors for all periods.

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. Foreign exchange markets are generally found to be at least semistrong-form efficient. 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. Forecasting Under Market Efficiency

Exchange Rate Volatility A more volatile currency has a larger expected forecast error. MNCs measure and forecast exchange rate volatility so that they canspecify a range (confidence interval) around their point estimate forecasts.

Exchange Rate Volatility Exchange rate volatility can be forecasted using:  Recent (historical) volatility,  A historical time series of volatilities (there may be a pattern in how the exchange rate volatility changes over time), and  The implied standard deviation derived from currency option prices.

Measurement to the exposure of Exchange Rate Fluctuations

Objectives To discuss the relevance of an MNC’s exposure to exchange rate risk; To explain how transaction exposure can be measured; To explain how economic exposure can be measured; and To explain how translation exposure can be measured.

Purchasing Power Parity When a country’s inflation rate rises, The demand for its currency declines. Imports increase Both of these forces put a downward pressure on high inflation country’s currency. Inflation rates often vary among countries and cause international trade and exchange rates to adjust. Purchasing power parity quantify the exchange rates to inflation rate relationship.

Is Exchange Rate Risk Relevant? Purchasing Power Parity Argument  Exchange rate movements will be matched by price movements. PPP does not necessarily hold.

One argument for exchange rate irrelevance is that, according to purchasing power parity (PPP) theory, exchange rate movements are just a response to differentials in price changes between countries. Therefore, the exchange rate effect is offset by the change in prices. Purchasing Power Parity Argument

Example Franklin Co. is a U.S. exporter that denominates its exports in Euros. If the euro weakens by 3 percent due to purchasing power parity. It implies that European inflation is about 3 percent higher than U.S. inflation.

Currency Diversification Argument Another argument is that if a U.S.-based MNC is well diversified across numerous countries, its value will not be affected by exchange rate movements because of offsetting effects. It is naive, however, to presume that exchange rate effects will offset each other just because an MNC has transactions in many different currencies.

Stakeholder Diversification Argument Some critics also argue that if stakeholders (such as creditors or stockholders) are well diversified, they will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. Many MNCs are similarly affected by exchange rate movements, however, so it is difficult to compose a diversified portfolio of stocks that will be insulated from exchange rate movements.

Response from MNCs Many MNCs have attempted to stabilize their earnings with hedging strategies because they believe exchange rate risk is relevant. Is Exchange Rate Risk Relevant?

Procter & Gamble Co. The primary purpose of the Company’s foreign currency hedging program is to manage the volatility associated with foreign currency purchases of materials and other assets and liabilities created in the normal course of business. Corporate policy prescribes a range of allowable hedging activity.

Dow Chemical Co. The Company enters into foreign exchange contracts and options to hedge various currency exposures.... the primary business objective of the activity is to optimize ¤ the U.S. dollar value of the Company’s assets, ¤ liabilities, and future cash flows With respect to exchange rate fluctuations.

Types of Exposure Although exchange rates cannot be forecasted with perfect accuracy, firms can at least measure their exposure to exchange rate fluctuations. Exposure to exchange rate fluctuations comes in three forms: ¤ Transaction exposure ¤ Economic exposure ¤ Translation exposure

Transaction Exposure The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. To measure transaction exposure:  Estimate the net cash inflows or outflows in each currency, and  Measure the potential impact of the exposure to those currencies.

Transaction Exposure Transaction exposure can have a substantial impact on a firm’s value. It is not unusual for a currency to change by as much as 10 percent in a given year. If an exporter denominates its exports in a foreign currency, a 10 percent decline in that currency will reduce the dollar value of its receivables by 10 percent. This effect could possibly eliminate any profits from exporting.

MNCs can usually anticipate foreign cash flows for an upcoming short-term period with reasonable accuracy. After the consolidated net currency flows for the entire MNC has been determined, each net flow is converted into a point estimate (or range) of a chosen currency. The exposure for each currency can then be assessed using the same measure. Estimating Net Currency Flows

Measuring the Potential Impact An MNC’s exposure can be measured by considering the proportion of each currency together with the currency’s variability and the correlations among the movements of the currencies. For a two-currency portfolio,

Review Forecasting Error Forecasting Services Forecasting Bias Diversification Argument Types of Exposure ¤ Transaction ¤ Economic ¤ Translation ¤ Source: Adopted from South-Western/ Thomson Learning 2006