Forecasting Exchange Rates

1. Forecasting Exchange Rates Rashedul Hasan

2. Why Firms Forecast Exchange Rates MNCs need exchange rate forecasts for their: Hedging decisions: MNCs constantly face the decision of whether to hedge future payables and receivables in foreign currencies. Short-term financing decisions When large corporation borrow, they have access to several different currencies. The currency they borrow will ideally (1) exhibit a low interest rate and (2) Weaken in value over the financing period.

3. Why Firms Forecast Exchange Rates Short-term investment decisions, Corporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies. The ideal currency for deposit will (1) exhibit a high interest rate and (2) Strengthen in value over the investment period.   Capital budgeting decisions When an MNCs 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. The capital budgeting analysis can be completed only when all estimated cash flows are measured in parent’s local currency.

4. Why Firms Forecast Exchange Rates Earnings assessment The parent’s decision about whether a foreign subsidiary should reinvest earnings in a foreign country or remit earnings back to the parent may be influenced by exchange rate forecasts. If a strong foreign currency is expected to weaken substantially against the parent’s currency, the parent may prefer to expedite the remittance of subsidiary earnings before the foreign currency weaken.

5. Forecasting Techniques Technical Forecasting Fundamental Forecasting Market-based Forecasting Mixed Forecasting

6. 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. However, since they typically focus on the near future and rarely provide point/range estimates, they are of limited use to MNCs

7. Technical Forecasting Tomorrow Kansas Co. has to pay 10 million Mexican Pesos for supplies that is recently received from Mexico. Today, the peso has appreciated by 3% against the dollar. Based on the analysis of historical time series, Kansas has determined that whenever the peso appreciated against the dollar by more than 1%, it experience a reversal of about 60% on the following day. Forecast the Tomorrow’s exchange rate for Kansas Co. and decide whether the Kansas Co. should pay the debts today instead of tomorrow?

8. Technical Forecasting • et+1 = et * (-60%) • = (3%) * (-60%) • = -1.8% • Given this forecast that the Peso will depreciate tomorrow, Kansas Co. should decided that it will make its payment tomorrow instead of Today.

9. Fundamental Forecasting • 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. • e = f (  INF,  INT,  INC,  GC  EXP) • A forecast may be based on quantitative measurements (with the aid of regression models and sensitivity analysis) too. • BP t = b0 + b1 INF t-1 + b2 INC t-1

10. Fundamental Forecasting Where, b0 = is a constant b1 = measures the sensitivity of BP t to changes in INF t-1 b2 = measures the sensitivity of BP t to changes in INC t-1  A regression analysis determines the direction and degree to which BP is affected by each independent variable. The coefficient b1 will show a positive sign when INF t-1 & BP t changes in the same direction. • A negative sign indicates that INF t-1 & BP t changes in negative direction.

11. Fundamental Forecasting Assume that, b0 =.002b1= .80 b2 = 1.0 INF t-1 = 4% & INC t-1 = 2%. We know, BP t = b0 + b1 INF t-1 + b2 INC t-1 = .002 + .8(4%) + 1(2%) = .2% + 3.2% + 2% = 5.4 % Given the current figures for inflation rates and income growth, the pound should appreciate by 5.4% during next quarter.

12. Market-Based Forecasting Market-based forecasting involves developing forecasts from market indicators. It is usually based on either the spot rate or the forward rate • Use of the spot rate Today’s spot rate may be use as a forecast of the spot rate that will exist on a future date. Assume the British pound is expected to appreciate against the dollar in the vary near future. This expectation will encourage speculators to buy the pound with U.S. dollar today anticipation of its appreciation, and these purchase can force the pound’s value up immediately

13. Market-Based Forecasting Use of the Forward rate A forward rate quoted for a specific date in the future is commonly used as the forecasted spot rate on that future date. For example, a 30 day forward rate provides a forecast for the spot rate in 30 days. Forward rate is measured as F = S (1+p) Where, P= Forward premium. Since p represent the % by which the forward rate exceeds the spot rate, it serves as the expected % change in the exchange rate E (e) = p = (F/S) – 1 [by rearranging value]

14. Market-Based Forecasting If the one year forward rate of the Australian dollar is $ .63, while the spot rate is $ .60. the expected percentage change in the Australian dollar is E (e) = p = (F/S) – 1 = (.63/.60) – 1 = .05 or 5%.

15. Mixed Forecasting Mixed forecasting refers to the use of a combination of forecasting techniques.

16. Comparison of Forecasting Techniques: Forecasts of the Mexican Peso drawn from each forecasting techniques