1. 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

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

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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

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

15. 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.

16. 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.

17. 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.

18. 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

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

20. 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