International Financial Management: INBU 4200

Fall Semester 2004Lecture 5: Part 1

Forecasting Exchange Rates

Forecasting Exchange Rates

• Why is it important to do so?– So that business firms can assess their

foreign exchange exposures.• Currencies they are dealing and the potential for

the exchange rate to move against them.– So that business firms can manage their

identified exposures.• Where they identify the potential for “large

negative” exposures, they can take steps to cover (hedge, or protect themselves).

Forecasting Approaches

• Efficient Market Approach– Applicable for short term (days out to a couple of

months)• Technical Approach

– Applicable for short term (days out to a couple of months).

• Fundamental Approach– Non-parity models: intermediate term (out to about a

year)– Parity models: long term (beyond one year)

Efficient Market Approach

• Assumes FX markets are efficient.– Current spot prices capture all relevant

information.– Spot exchange rates will only occur when the

market received “new” information.– Since “new” information is unpredictable,

exchange rates will change randomly over time.

• No way to predict future spot rates.

Efficient Market Forecasting

• Future spot rates are assumed to be independent of past rates.– “Random Walk.”

• What can we use to forecast?– The current spot rate or – The current forward rate.

Efficient Markets Summary• Benefits:

– Easy to use.– Costless (spot and forwards are public rates;

observable).

• Disadvantages:– Only way to beat (“do better than”) the market is if you

have “insider” information.

• Approach may be useful for relatively short term periods (out to a couple of months).– Also depends upon the exchange rate regime.

Technical Analysis• Examines past price data in an attempt to

identify “patterns.”– Patterns with regard to prices (and perhaps volume). – Relies on charts!

• Patterns can be used to signal future moves in rates.– Assumes historical patterns will “repeat” themselves

and thus are useful in predicting future moves in exchange rates.

– Suggests that prices are not random!– Method at odds with efficient market approach.

Technical Analysis Approaches • Market Momentum

– Examine past charts to identify if market momentum exists.

• Has the currency exhibited historical strength or weakness?• Look at last two years, last 3 months, last month.• Compare daily moves to longer term trend.• Examine historical extremes in rates.

– Based upon the above, what is the “anticipated” trend in market momentum?

• Will current strength or weakness continue, or• Will current strength or weakness reverse?

• Recommendation: use web-sites to chart data.– http://fx.sauder.ubc.ca/

Canadian Dollar (CAD): Last 2 Years

• What has been the 2 year trend?

Canadian Dollar (CAD): Last 91 Days

• What has been the 3 month trend?

Canadian Dollar (CAD): Last 31 Days

• What has been the 1 month trend?

Daily Spot to Trend: Moving Average Cross Over Rule

• Compare current spot rate to longer term (90 or 180 day) moving average of past spot rates.

• Look for crossover of two series:– If current spot crosses trend on way up, this is a

signal of currency strength.– If current spot crosses trend on way down, this is a

signal of currency weakness.

• Present chart so that it “correctly” shows currency strength or weakness.– Relate to quote: Is it American or European terms?

Spot to 90-day Moving Average• Note: Scale has been inverted to show trend (CAD is

European terms quoted currency)• What does this chart suggest?

Bollinger Band Indicator Analysis• Bollinger Band Analysis:

– Allows for comparison of volatility and relative price levels over a period of time. The indicator consists of three bands designed to encompass the majority of a foreign exchange’s price action over some past period of time. These are:

1. A simple moving average of the spot rates (SMA) in the middle of the band.2. An upper band of the spot rates (SMA plus 2 standard deviations)3. A lower band of the spot rates (SMA minus 2 standard deviations)

• Standard deviation is a statistical term that provides an indication of the currency’s volatility.

Interpretation of Bollinger Band Indicators

• Assumption: Bollinger Bands are assumed to capture the majority of a currency’s price movement. – When prices move above the upper band (SMA plus 2

standard deviations), currencies are considered overbought (and thus spot prices are high).

• Signal of future weakness in currency

– When prices move below the lower band (SMA minus 2 standard deviations) currencies are considered oversold (and thus spot prices are low).

• Signal of future strength in currency

Bollinger Bands (90-day Average Green Line)

• Look at current and historical signals.

Fundamental Analysis• Focus: What are the relative economic forces that may

drive the spot exchange rate in the future?

• Non-Parity Models:– Assets Choice Model

• Why do foreign exchange markets desire to hold one currency over another?

– Balance of Payments Model• How do balance of payments accounts affect the exchange rate?• Both combined with “government intervention activity.”• Both combined with “country risk assessment.”

• Parity Models– Purchasing Power Parity– International Fisher Effect

Asset Choice Model

• What are the major economic and financial variables that will result in an increase (or decrease) in the demand for a particular currency.– Increase in demand will cause the currency’s

spot rate to strengthen.– Decrease in demand will cause the currency’s

spot rate to weaken.

Asset Choice Variables• Relative Interest Rates

– Countries with relatively higher short term interest rates will experience increased short term capital inflows.

– Thus, demand for the currency increases.– Inflows of short term capital, resulting in demand increases, will

strengthen a currency’s spot rate.• Examine current short term interest rates in the two

countries.– Look at relative rates.

• Also assess the potential for changes in short term interest rates (and thus, changes in the interest rate differential) in both countries.– Which country appears to be the most attractive for short term

investing.

Interest Rate Data

• Use Bloomberg or the Economist (or other sources) for current short term interest rates.– http://www.bloomberg.com/markets/rates/inde

x.html– http://www.economist.com/

Assessing Future Short Term Interest Rates

• Where are short term interest rates likely to move over the period of your forecast?

• What are the major factors that will impact on short term interest rates?– Economic activity.

• Based on the pro-cyclical nature of interest rates.– Central bank interest rate decisions.

• Need to assess both of these.• Also look at yield curves to market’s expectation

regarding future moves in short term rates.

Where to View Central Bank Decisions and Announcements

• Visit the web sites of central banks for latest announcements and past decisions.

• http://www.bis.org/cb/index.htm

Additional Asset Choice Variables

• Equity Market Performance– Strong equity markets will also pull in capital from

foreign investors.– This results in an increase in the demand for a

currency.– Thus, capital inflows, resulting from equity market

performance, will strengthen a currency.• Assess recent moves in major equity markets.• What is the outlook for equity markets over the

period of the forecast?

Government Intervention Policies

• Governments may intervene in foreign exchange markets to support their currency.

• Depends upon the foreign exchange regime.• Government actions take the form of:

– Selling a strengthen currency (increasing supply)– Buying a weakening currency (increasing demand)

• Government intervention can affect the spot exchange rate.

• Why important?– May offset initial your forecast for the currency.

Country Risk Assessment• Generally speaking, markets tend to discount

the currencies of “high risk environments.”– Markets reluctant to hold these currencies.– Tends to weaken a currency

• Thus we need to assess country risk– A country’s unique political and economic risk factors.

• One source of country risk is Institutional Investor Magazine.

• Another source, relating to corruption, is Transparency International.

SOURCES OF DATA

• http://www.transparency.org/– Go to “Corruption Surveys.”– Indication of “Political” environment situation.

• Institutional Investor Magazine– In Business School Library

Balance of Payments Model

• Examine a country’s balance of payments accounts to determine possible exchange rate impacts.– High (trade and current account) deficit countries

need a lot of foreign capital to finance these deficits.• Tends to put downward pressure on the exchange rate of

these countries.

– High (trade and current account) surplus countries are already pulling in foreign capital

• Tends to put upward pressure on the exchange rate of these countries.

Parity Models: Review• Purchasing Power Parity Model

– Use absolute PPP model to assess whether or not a currency is currently over or undervalued.

– Big Mac Index or OECD data.• Use forecasts of expected inflation to estimate

changes in spot rates for the time period of the forecast.– Relative PPP model– The Economist Magazine as one source of expected

inflation.• “Economic and Financial Indicators section.”

Parity Models: Review• International Fisher Effect

– Collect market interest rate data for the period of the forecast.

– For example, a ten year forecast would necessitate looking at ten year government securities.

• Based on market interest rate differentials, estimate future spot rates for the time period of the forecast.– Note: This parity model’s assumption about the

relationship of interest rates to exchange rates is opposite to the asset choice model.

Sources of Market Interest Rate Data

• Bloomberg

• The Economist Magazine• Economic and Financial Indicators section.”

• Important: – Make sure the maturity of the securities you

are selecting matches the time period of the forecast!