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Methods of Forecasting Forex Rates

This document discusses methods that firms use to forecast exchange rates. It covers technical forecasting using historical data and statistical analysis, fundamental forecasting based on economic factors that influence exchange rates, and market-based forecasting using current spot and forward rates. It also discusses mixed forecasting, where firms combine multiple methods by assigning weights. Accurate exchange rate forecasts are important for multinational corporations' hedging, financing, investment, and earnings assessment decisions.

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131 views

Methods of Forecasting Forex Rates

This document discusses methods that firms use to forecast exchange rates. It covers technical forecasting using historical data and statistical analysis, fundamental forecasting based on economic factors that influence exchange rates, and market-based forecasting using current spot and forward rates. It also discusses mixed forecasting, where firms combine multiple methods by assigning weights. Accurate exchange rate forecasts are important for multinational corporations' hedging, financing, investment, and earnings assessment decisions.

Uploaded by

Dulcet Lyrics
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© © All Rights Reserved
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Download as PPTX, PDF, TXT or read online on Scribd
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Methods of Forecasting Forex

Rates
 What is Exchange Rate….?

Exchange Rate implies how much strong is one currency


to another.

For example:-
An exchange rate of 91 Japnese Yen (JPY, ¥) to the United States
Doller (USD, $) means that
91 JPY = 1 USD
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
– Earnings Assessment
Why Firms Forecast Exchange Rates
• Hedging Decision
– MNCs constantly face the decision of whether to hedge future
payables and receivables in foreign currencies.
– Whether a firm hedges may be determined by its forecasts of
foreign currency values.

• Short-term Financing Decision


– When large corporations borrow, they have access to several
different currencies.
– The currency they borrow will ideally exhibit:
1) a low interest rate and
2) weaken in value over the financing period.
Why Firms Forecast Exchange Rates
• Short-term Investment Decision
– Corporations sometimes have a substantial amount of excess
cash available for a short time period.
– The ideal currency they deposits ideally exhibit:
1) a high interest rate and
2) strengthen in value over the investment period.

• Capital Budgeting Decision


– When an MNC’s parent assesses whether to invest funds in a
foreign project, the firm takes into account that:
– The project may periodically require the exchange of
currencies.
– Analysis can be completed only when all estimated cash flows
are measured in the parent’s local currency.
Why Firms Forecast Exchange Rates
• Earnings Assessment
– The parent’s decision about whether a foreign subsidiary:
 Reinvest earnings in a foreign country or
 Remit earnings back to the parent.

– Decision may be influenced by exchange rate forecasts.


 If a strong foreign currency is expected to weaken
substantially, the parent may prefer to expedite the
remittance earnings before the foreign currency weakens.

– When earnings of an MNC are reported, subsidiary earnings


are consolidated and translated into the currency
representing the parent firm’s home country.
Why Firms Forecast Exchange Rates
• Long-term Financing Decision
– Corporations that issue bonds to secure long-term funds may
prefer that the currency borrowed, depreciate over time against
the currency they are receiving from sales.
– To estimate the cost of issuing bonds denominated in a foreign
currency, forecasts of exchange rates are required.
Forecasting Techniques
• Numerous methods available for forecasting
exchange rates can be categorized into four general
groups:

1. Technical Forecasting Market-based


Forecasting
2. Fundamental Forecasting Technical Forecasting

3. Market Based Forecasting


4. Mixed Forecasting Fundamental
Mixed Forecasting

Forecasting
Forecasting Techniques
• Technical Forecasting
– Technical forecasting involves the use of historical
exchange rate data to predict future values.
– There may be a trend of successive exchange rate
adjustments in the same direction.
– It includes statistical analysis(charting) and time series
models.
– Speculators may find the models useful for predicting
day-to-day movements.
Technical
Forecasting

Time Series
Charting
Models

Data Sentiment Flow of Fund


Indicators Indicator Indicator
Forecasting Techniques
• Fundamental Forecasting
– Fundamental forecasting is based on fundamental
relationships between economic variables &
exchange rates.
– A forecast may arise simply from a subjective
assessment of the factors that affect exchange rates.
– Changes in a currency’s spot rate is influenced by the
following factors:
Forecasting Exchange Rates:
Fundamental
• Limitation of fundamental forecasting
methods:
– Uncertain Timing of Impact
– Forecast Needed for factors with Instantaneous
Impact
– Omission of other Relevant Factors from Model
– Sensitivity of Parameters to Various Factors Over
Time
PRICE AND EXCHANGE RATE : MODELS
 Random Walk Approach

 Uncovered Interest Rate Parity (UIP)

 Purchasing Power Parity (PPP)

 Law of one price.

 Interest rates parity

 Investor psychology and “Bandwagon” effects


LAW OF ONE PRICE

 In competitive markets free of transportation costs and


trade barriers, identical products sold in different
countries must sell for the same price when their price
is expressed in terms of the same currency.

For Ex : US/French exchange rate: $1 = .78Eur A jacket


selling for $50 in New York should retail for 39.24Eur in
Paris (50x.78).
PURCHASING POWER PARITY

 By comparing the prices of identical products in


different currencies, it should be possible to determine
the ‘real’ or PPP exchange rate - if markets were
efficient.

 In relatively efficient markets (few impediments to


trade and investment) then a ‘basket of goods’ should
be roughly equivalent in each country.
MONEY SUPPLY AND INFLATION

 PPP theory predicts that changes in relative prices


will result in a change in exchange rates,
 A country with high inflation should expect its currency
to depreciate against the currency of a country with a
lower inflation rate
 Inflation occurs when the money supply increases faster
than output increases
 Purchasing power parity puzzle
INTEREST RATE AND EXCHANGE
RATE
 Theory says that interest rates reflect expectations
about future exchange rates.
 Fisher Effect (I = r + l).
 International Fisher Effect:
 For any two countries, the spot exchange rate
should change in an equal amount but in the
opposite direction to the difference in nominal
interest rates between the two countries.
INVESTOR PSYCHOLOGY AND
BANDWAGON EFFECTS
 Evidence suggests that neither PPP nor the
International Fisher Effect are good at explaining
short term movements in exchange rates
 Explanation may be investor psychology and the
bandwagon effect
 Studies suggest they play a major role in short term
movements
 Hard to predict
Forecasting Techniques
• Market-Based Forecasting
– The process of developing forecasts from market
indicators, is usually based on either;
1. Spot rate or
2. Forward rate.
– Speculation should push the rates to the level that
reflect the market expectation of the future exchange
rate.
– Corporations can use the spot rate to forecast since it
represents the market’s expectation of the spot rate in
the near future.
Forecasting Techniques
• Mixed Forecasting

 Mixed forecasting is used because no one method has


been found superior to another
 Multinational corporations use a combination of
methods
 Assign a weight to each technique and the forecast is a
weighted average
 Perhaps a weighted combination of technical,
fundamental, and market-based forecasting
Exhibit 9.2 Forecasts of the Mexican Peso Drawn from Each
Forecasting Technique
Forecasts of the Mexican Peso Drawn from Each
Forecasting Technique

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