Chapter

Forecasting Exchange
Rates

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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Why Firms Forecast Exchange Rates

Hedging Decisions
Short-term Financing Decisions
Short-term Investment Decisions
Capital Budgeting Decisions
Earnings Assessments
Long-term financing Decisions

Why Firms Forecast Exchange Rates

Forecasting Techniques
Forecasting techniques can be
categorized into four general groups:

Technical
Fundamental
Market-based and
Mixed.

1. Technical Forecasting
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.
A technical forecasting model that worked
well in one particular period may not
necessarily work well in another period.
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1. Technical Forecasting - Limitations

1. Since they typically focus on the near
future (typical one day).
2. Example: et+1 = et x (-60%) when et > 1%
so, if MXP appreciates by 3% on day t
then next day (t+1) it will depreciate by
3% x (-60%) = -1.8%

2. Fundamental Forecasting
Fundamental forecasting is based on the
fundamental relationships between
economic variables and exchange rates.
e = f (INF, INT, INC, GC, EXP)

2. Fundamental Forecasting
A forecast may be based on
1.

subjective assessment of the factors that

affect exchange rates. or

2.

on quantitative measurements (with the aid

of regression models and sensitivity analysis)
too.
Example:
BPt = b0 + b1INFt-1 + b2 INCt-1 + et

INFt-1, INCt-1= Interest and income differential between two

countries.
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2. Fundamental Forecasting Use of PPP

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 (e.g.
Interest difference)
10

2. Fundamental Forecasting Limitations

I.
II.
III.

IV.

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 (eg.
strike)
changes in the sensitivity of currency
movements to each factor over time (non
constant coefficients).
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3. Market-Based Forecasting
Market-based forecasting involves
developing forecasts from market
indicators.
Usually, it is based on
1. the spot rate or
2. the forward rate.
Since speculation should push the rates to
the level that reflect the market
expectation of the future exchange rate.
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3. Market-Based Forecasting
F = S(1+P)
E(e) = p = (F/S) 1
Here

e = expected change in the spot rate

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.
1 iIQ
p
1
1 iDQ
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4. Mixed Forecasting
Since no one method has been found
fool proof, a combination of forecasting
techniques is used which is called
mixed forecasting.
the techniques are assigned a weight
that totals 100 points
more reliable techniques assigned a
higher weights.
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Forecasting methods

15

Forecasting Services
Business International
Conti Currency
Predex
Global Insight

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Forecasting Error
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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Forecasting Error
What is the Potential Impact of
Forecast Errors?

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Forecasting Error
1. Forecast Accuracy over Time
Absolute Forecast Error (as % of Realized Value) for the British Pound over Time

19

Exhibit 9.3 Absolute Forecast Errors over Time for the

British Pound (Using the Forward Rate to Forecast)

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Forecasting Error
Error
Currency

Value

Mean Absolute Forecast

as a Percent of the Realized

1974-1998 1974-1984 1985-

1998
British pound
Canadian dollar
Japanese yen
Swiss franc

4.61 %
1.73
5.60
5.69

5.06 %
1.70
5.22
5.81

4.21 %
1.75
5.93
5.58
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Forecasting Error
2. Forecast Accuracy among Currencies

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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Forecasting 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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Graphic Evaluation of Forecast Performance

Biased if
consistently
above or
below the
line.
Unbiased if
sometimes
above and
sometimes
below the

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Graphic Comparison of Forecasted and Realized Spot

Rates in Different Sub periods for the British Pound
(Using the Forward Rate as the Forecast)

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Graphic Comparison of Forecasted and Realized Spot

Rates in Different Sub periods for the British Pound
(Using the Forward Rate as the Forecast)

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Graphic Comparison of Forecasted and Realized Spot

Rates in Different Sub periods for the British Pound
(Using the Forward Rate as the Forecast)

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Comparisons of Forecasting Methods

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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Comparisons of Forecasting Methods

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Forecasting Under Market Efficiency

1. Weak-form efficient
2. Semi-strong-form efficient
3. Strong-form efficient
Foreign exchange markets are generally
found to be at least semi-strong form
efficient.

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Forecasting Under Market Efficiency

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.
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Using Interval Forecasts

MNCs may specify an interval around
their point estimate forecast.
The measurement of a currencys
volatility is useful for specifying an
interval around a forecast.
Volatility measurement enables them
to specify a range and develop bestcase and worst-case scenarios along
with their point estimate forecasts. 32

Methods of Forecasting Exchange Rate Volatility

Popular methods for forecasting volatility
include:
the use of recent 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 rates

implied standard deviation from the

currency option pricing model.

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Useful link
http://www.oanda.com/
http://www.forex.com/tradingplatforms/forextrader.html

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Quiz
Which of the following forecasting techniques would
best represent sole use of todays spot exchange rate of
the euro to forecast the euros future exchange rate?
A)
B)
C)
D)

fundamental forecasting.
marketbased forecasting.
technical forecasting.
mixed forecasting.

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Quiz
Which of the following forecasting techniques would
best represent sole use of todays spot exchange rate of
the euro to forecast the euros future exchange rate?
A)
B)
C)
D)

fundamental forecasting.
marketbased forecasting.
technical forecasting.
mixed forecasting.

ANSWER: B
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Quiz
Assume the following information:
Period
1
2
3
4

Predicted Value of Realized Value of

New Zealand Dollar
New Zealand Dollar
$.52
$.50
.54
.60
.44
.40
.51
.50

Given this information, the mean absolute forecast error as a percentage of the
realized value is about:
A)
1.5%.
B)
26%.
C)
6%.
D)
6.5%.
E)
none of these.

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Quiz
Assume the following information:
Predicted Value of
Period New Zealand Dollar
1
$.52
2
.54
3
.44
4
.51

Realized Value of
New Zealand Dollar
$.50
.60
.40
.50

Given this information, the mean absolute forecast error as a percentage of the realized
value is about:
A)
1.5%.
B)
26%.
C)
6%.
D)
6.5%.
E)
none of these.
SOLUTION: [($.52 $.50)/$.50 + ($.54 $.60)/$.60 + ($.44 $.40)/$.40 + ($.51
$.50)/$.50]/4 = [.04 + .10 + .10 + .02]/4 = .065 = 6.50%
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Quiz
A fundamental forecast that uses multiple values of the
influential factors is an example of:
A)
B)
C)
D)

sensitivity analysis.
discriminant analysis.
technical analysis.
factor analysis.

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Quiz
A fundamental forecast that uses multiple values of the
influential factors is an example of:
A)
B)
C)
D)

sensitivity analysis.
discriminant analysis.
technical analysis.
factor analysis.

ANSWER: A

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Quiz
Assume that the forward rate is used to forecast the spot
rate. The forward rate of the Canadian dollar contains a
6% discount. Todays spot rate of the Canadian dollar is
$.80. The spot rate forecasted for one year ahead is:
A)
B)
C)
D)
E)

$.860.
$.848.
$.740.
$.752.
none of these.
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Quiz
Assume that the forward rate is used to forecast the spot
rate. The forward rate of the Canadian dollar contains a
6% discount. Todays spot rate of the Canadian dollar is
$.80. The spot rate forecasted for one year ahead is:
A)
B)
C)
D)
E)

$.860.
$.848.
$.740.
$.752.
none of these.

ANSWER: D = $0.80*(1-0.06) = $0.752

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