Part IIIExchange 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

ratesManaging

exposure to exchange rate fluctuations

Forecasting Exchange RatesForecasting Exchange Rates

99 Chapter Chapter

South-Western/Thomson Learning © 2003

See c9.xls for spreadsheets to accompany this chapter.

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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.

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• 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 ForecastExchange Rates

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Forecasting Techniques

• The numerous methods available for forecasting exchange rates can be categorized into four general groups: technical, fundamental, market-based,and mixed.

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• 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

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• 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

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• 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

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• 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

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• 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

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• 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

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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.

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• Visit http://www.yardeni.com for reviews of international political and economic events and their presumed global impact. The site also presents economic and political analyses of major economies.

• Country outlooks and exchange rate forecasts can also be found at http://biz.yahoo.com/ifc/.

Online Application

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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.

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• 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

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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.

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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.

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Evaluation of Forecast PerformanceUsing the Forward Rate as a Forecast for the British Pound

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

1975 1980 1985 1990 1995 2000Ab

solu

te F

ore

cast

Err

or

($)

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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.

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Mean Absolute Forecast ErrorCurrency as a Percent of the Realized Value

1974-1998 1974-1984 1985-1998

British pound 4.61 % 5.06 % 4.21 %

Canadian dollar 1.73 1.70 1.75

Japanese yen 5.60 5.22 5.93

Swiss franc 5.69 5.81 5.58

Evaluation of Forecast Performance

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Forecast Bias

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

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Forecast BiasUsing the Forward Rate as a Forecast for the British Pound

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$2.20

$2.40

$2.60

1975 1980 1985 1990 1995 2000

Forward Rate

RealizedSpot Rate

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Forecast Bias

• The following regression model can be used to test for forecast bias: realized = a0 + a1 forecast +

• If a predictor is found to be biased, the estimated a0 and a1 values can be used to

correct the systematic error.

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Graphic Evaluation of Forecast Performance

Perfect forecast line

x z

x

zR

eali

zed

Val

ue

Predicted Value

Region of downward bias

(underestimating)

Region ofupward bias

(overestimating)

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Graphic Evaluation of Forecast PerformanceUsing the Forward Rate as a Forecast for the British Pound

Rea

lize

d S

po

t R

ate

$1.00

$1.50

$2.00

$2.50

$1.00 $1.50 $2.00 $2.50

Forecast (Forward Rate)

PerfectForecast

Line

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Graphic Evaluationof 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.

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Comparison ofForecasting 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.

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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.

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• 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

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• 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

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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,

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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.

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• Various foreign exchange resources, including exchange rate volatility based on historical exchange rate movements, can be found at http://www.oanda.com and http://pacific.commerce.ubc.ca/xr/.

Online Application

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Application of Exchange Rate Forecastingto 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.

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Application of Exchange Rate Forecastingto 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.

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Impact of Forecasted Exchange Rateson an MNC’s Value

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Technical ForecastingFundamental ForecastingMarket-based Forecasting

Mixed Forecasting

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• Why Firms Forecast Exchange Rates

• Forecasting Techniques¤ Technical Forecasting¤ Fundamental Forecasting¤ Market-Based Forecasting¤ Mixed Forecasting

• Forecasting Services¤ Performance of Forecasting Services

Chapter Review

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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

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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