1. Chapter 8 Exchange Rate Forecasting, Technical Analysis and Trading Rules

2. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Objectives To explain why exchange rate forecasting is needed To illustrate forecasting techniques To explain how to evaluate the performance of forecasters 8-2 (cont.)

3. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Objectives (cont.) To demonstrate how technical analysis is used to generate buy and sell signals To explain how filter rules and moving average rules work 8-3

4. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Definition Forecasting is a formal process of generating expectation Expectations are implicit forecasts 8-4

5. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Why do we need exchange rate forecasting? Spot speculation Uncovered interest arbitrage Spot-forward speculation Option speculation Hedging Investment and capital budgeting 8-5 (cont.)

6. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Why do we need exchange rate forecasting? (cont.) Financing decisions Pricing decisions Strategic planning Macroeconomic conditions Central bank intervention 8-6

7. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Econometric forecasting models These are models that are specified on the basis of economic theory and estimated by an econometric method They are classified into single-equation and multi- equation models 8-7

8. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Single-equation models The exchange rate (or its rate of change) depends on one or more variables: 8-8

9. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Examples of single-equation models 8-9

10. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Problems of single-equation models The ‘black box’ problem Forecasting the explanatory variables Data frequency Structural changes Measurement errors Qualitative variables 8-10

11. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Multi-equation models The ‘black box’ problem can be solved by specifying a multi-equation model 8-11

12. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Time series models These are based entirely on the history of the exchange rate: 8-12 (cont.)

13. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Time series models (cont.) Exchange rates move predominantly in cycles with significant random variation 8-13

14. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Cycles of the US dollar’s effective exchange rate 8-14

15. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Problem with time series models If the FX market is weakly efficient, the exchange rate must follow a random walk. Hence, it is not possible to forecast the exchange rate based on its history 8-15

16. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Market-based forecasting Using the current market spot and forward rates as forecasters for the future spot rate This means that market-based forecasts are free and readily available 8-16 (cont.)

17. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Market-based forecasting (cont.) The reliability of market-based forecasts depends on the validity of the random walk hypothesis and the unbiased efficiency hypothesis 8-17

18. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Spot and lagged forward exchange rates (USD/AUD) 8-18

19. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa The forward rate forecasting error as a percentage of the spot rate 8-19

20. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Judgmental forecasting Judgmental forecasting takes into account all factors affecting exchange rates It is not based on a formula derived from a formal model 8-20

21. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Composite forecasting Composite forecasting is based on two or more forecasts that are derived independently Forecasting accuracy can be increased by pooling different forecasts 8-21

22. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Combining forecasts 8-22

23. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Why composite forecasting? Different forecasters have different degrees of forecasting accuracy Diversification reduces the risk of large forecasting errors 8-23

24. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Forecasting performance evaluation Performance out of sample is more meaningful The loss function is important 8-24

25. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Measures of forecasting accuracy Mean absolute error (MAE) Mean square error (MSE) Root mean square error (RMSE) 8-25

26. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Magnitude versus direction Sometimes it is more important to predict the direction rather than the magnitude of the change The prediction-realisation diagram can be used to represent magnitude and direction errors 8-26

27. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa The prediction-realisation diagram G C F D E B A H Line of perfect forecast Forecast change Actual change 8-27

28. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Technical analysis Technical analysis comprises a variety of practices and procedures used to forecast exchange rates It ignores the role of fundamentals 8-28

29. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Rationale for technical analysis Exchange rates are determined by supply and demand Supply and demand are governed by rational and irrational factors Changes in trend are caused by shifts in supply and demand History repeats itself 8-29

30. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Kinds of charts Line charts Bar charts Point and figure charts 8-30

31. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa A bar chart Closing High Low S Time 8-31

32. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Chart formations Chartists study charts of exchange rate movements to identify certain patterns 8-32

33. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Trendlines and trading ranges Trendlines connect ascending bottoms and descending tops The market is in a trading range when the tops and bottoms are at the same level 8-33

34. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Trendlines and trend channels S Time (a) Upward trend (bull market) 8-34 (cont.)

35. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Trendlines and trend channels (cont.) S Time (b) Downward trend (bear market) 8-35 (cont.)

36. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Trendlines and trend channels (cont.) S Time (c) Sideways trend (trading range) 8-36

37. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Support and resistance levels A support level is the bottom of a market swing A resistance level is a point where the market peaks and the exchange rate reverses an upward move 8-37

38. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Creation of resistance and support levels Time S 8-38

39. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Flags A flag is a continuation pattern A flag occurs when a major trend is interrupted 8-39

40. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Triangles An ascending triangle appears when buyers come to the market at progressively higher levels. Otherwise it will be a descending triangle A symmetrical triangle is difficult to interpret 8-40

41. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Head and shoulders This formation indicates the reversal of an upward trend A reverse head and shoulders formation implies the opposite 8-41 (cont.)

42. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Head and shoulders (cont.) Head Neckline Shoulder Time S 8-42

43. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Reverse head and shoulders Head Neckline Shoulder Time S 8-43

44. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Market efficiency and trading rules Market efficiency implies that it is not possible to make profit by adopting a mechanical trading rule or by following buy-sell signals extracted from charts 8-44

45. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Filter rules An x% filter rule means that a currency is bought when it appreciates by x% from the most recent trough and is sold when it depreciates by x% from the most recent peak 8-45

46. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa A single moving average rule A single moving average rule means that a currency is bought when the moving average cuts the exchange rate series from above and is sold otherwise 8-46 (cont.)

47. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa A single moving average rule (cont.) 8-47

48. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Double moving average rule A double moving average rule says that a buy signal is indicated when the long moving average crosses the short moving average from above, and vice versa 8-48