Part III

Exchange Rate Risk Management

Information on existing Information on existing
and anticipated and anticipated
economic conditions of cash flows in
various countries and each currency
on historical exchange at each subsidiary
rate movements

Forecasting Measuring
exchange exposure to
rates Managing exchange rate
exposure to fluctuations
exchange rate
fluctuations
 Chapter 9
Forecasting Exchange Rates
 Chapter Objectives

• To explain how firms can benefit

from forecasting exchange rates.
• To describe the common techniques
used for forecasting.
• To explain how forecasting
performance can be evaluated.
 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
– earnings assessments
– long-term financing decisions
Corporate Motives for Forecasting Exchange Rates

Decide whether to
hedge foreign
currency cash flows

Decide whether to Home

invest in foreign 1QA\
cash
Forecasting projects flows
exchange
rates
Decide whether Value
foreign subsidiaries 1QA\
of the
should remit earnings firm

Decide whether to Cost

obtain financing in of
foreign currencies capital
 Forecasting Techniques
• The numerous methods available for
forecasting exchange rates can be
categorized into four general groups:
1. technical
2. fundamental
3. market-based
4. mixed
 Technical Forecasting
• Technical forecasting involves the use of
historical data to predict future values, in
essence patterns.
• Market efficiency states that such
predictions are not consistently better than a
no change prediction.
• Speculators may find the models useful for
predicting day-to-day movements.
• They are likely to mislead MNCs.
Fundamental Forecasting (1)
• Fundamental forecasting is based on the
fundamental relationships between
economic variables and exchange rates.
– E.g. subjective assessments, quantitative
measurements based on regression models and
sensitivity analyses.
• Changes the problem from predicting the
exchange rate to predicting economic
variables that influence the exchange rate.
This is no easier!
 Fundamental Forecasting (2)
• In general, fundamental forecasting is limited by:
– the uncertain timing of the impact of the factors,
– the need to forecast factors that have an
immediate impact on exchange rates,
– the omission of factors that are not easily
quantifiable, and
– changes in the sensitivity of currency
movements to each factor over time.
 Market-Based Forecasting
• Market-based forecasting uses market
indicators to develop forecasts.
• The current spot or forward rates* are
often used, since speculators will ensure
that the current rates reflect the market
expectation of the future exchange rate.
• For long-term forecasting, the interest
rates on risk-free instruments can be
used under conditions of IRP.
* Note that the forward rate is not better informed than the spot!
 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.
 Forecasting Services
• The corporate need to forecast currency
values has prompted some consulting
firms and investment/commercial banks
to offer forecasting services.
• One way to determine the value of a
forecasting service is to compare the
accuracy of its forecasts to that of
publicly available and free forecasts.
 Evaluation of Forecast
Performance (1)
• An MNC that forecasts exchange rates
should monitor its performance over time to
determine whether its forecasting procedure
is satisfactory.
• One popular measure, the absolute forecast
error as a percentage of the realized value,
is defined as:
| forecasted value – realized value |
realized value
 Absolute Forecast Errors over Time
Using the Forward Rate as a Forecast for the British Pound
 Evaluation of Forecast
Performance (2)
• MNCs are likely to have more confidence
in their forecasts as they measure their
forecast error over time.
• Forecast accuracy varies among
currencies. A more stable currency can
usually be more accurately predicted.
• If the forecast errors are consistently
positive or negative over time, then there
is a bias in the forecasting procedure.
 Comparison of Forecasting
Methods
• The different forecasting methods can
be evaluated:
– Graphically—by visually comparing the
deviations from the perfect forecast line,
or
– Statistically—by computing the forecast
errors for all periods.
 Forecasting Under Market
Efficiency (1)
•Market efficiency states that prices reflect
information about the asset in an efficient
market.
• This is a general statement, relevant here
to the price of a foreign currency. Often
applied to shares but could be applied to
any product such as a car.
•There are three forms of testing to see if
the price really does react to information
about, in this case, a currency.
 Forecasting Under Market
Efficiency (2)
• If the foreign exchange market is
weak-form efficient, then the
exchange rates will move randomly
because information is randomly
better or worse than we expected!
Randomness is the “footprint” of
information.
 Forecasting Under Market
Efficiency (3)
• 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.
 Forecasting Under Market
Efficiency (4)
• Testing for efficiency:

• Weak form efficient: test for randomness of the

price (exchange rate) movements

• Semi strong and strong form: identify the

announcement of a significant piece of information
(e.g. balance of payments figures) and see if there
was a significant movement in the exchange rate –
an event study. Semi strong IF the movement was
immediately after the announcement, strong if
BEFORE the announcement!
 Forecasting Under Market
Efficiency (5)
• Testing for efficiency:

• Markets seek semi strong efficiency

• Strong form suggests corruption
• Tests can only find inefficiency. A failure to find
inefficiency does NOT mean that all changes in
currencies reflect information. We would have to
test all changes and that is not possible!
• Tests generally find semi strong efficiency price
movements are random and the markets react
immediately following a significant announcement.
 Forecasting Under Market
Efficiency (6)
• Market efficiency implies that the SPOT rate
is the best predictor of the future exchange
rate!
• Why? Because all that is known about the
future value is discounted into the spot rate.
• But MNCs are also interested in the range
of possible exchange rates in order to
measure RISK
 Exchange Rate Volatility (1)

• A more volatile currency has a larger

expected forecast error.
• MNCs measure and forecast
exchange rate volatility so that they
can specify a range (confidence
interval) around their point estimate
forecasts.
 Exchange Rate Volatility (2)

• Exchange rate volatility can be

forecasted using:
1. recent (historical) volatility
2. a historical time series of volatilities
(there may be a pattern in how the
exchange rate volatility changes over
time)
3. the implied standard deviation derived
from currency option prices.
 Exchange Rate Volatility (3)

• Of particular concern in forecasting

are the large exchange rate
movements.
• These lie outside the normal
distribution
• Statistically these outliers are difficult
to predict, subjective judgement by
economists and financiers is all that is
left!