International Financial Management: INBU 4200 Fall Semester 2004

1. International Financial Management: INBU 4200Fall Semester 2004 Lecture 5: Part 1 Forecasting Exchange Rates

2. 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).

3. 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)

4. 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.

5. 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 rateor • The current forward rate.

6. 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.

7. 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.

8. 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/

9. Canadian Dollar (CAD): Last 2 Years • What has been the 2 year trend?

10. Canadian Dollar (CAD): Last 91 Days • What has been the 3 month trend?

11. Canadian Dollar (CAD): Last 31 Days • What has been the 1 month trend?

12. 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 currentspot 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?

13. 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?

14. Bollinger Band Indicator Analysis • Bollinger Band Analysis: • Allows for comparison ofvolatility 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.

15. 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

16. Bollinger Bands (90-day Average Green Line) • Look at current and historical signals.

17. 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

18. 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.

19. Asset Choice Variables • Relative Interest Rates • Countries with relatively higher short term interestrates 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.

20. Interest Rate Data • Use Bloomberg or the Economist (or other sources) for current short term interest rates. • http://www.bloomberg.com/markets/rates/index.html • http://www.economist.com/

21. 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.

22. 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

23. 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?

24. 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.

25. 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.

26. SOURCES OF DATA • http://www.transparency.org/ • Go to “Corruption Surveys.” • Indication of “Political” environment situation. • Institutional Investor Magazine • In Business School Library

27. 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.

28. 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.”

29. 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.

30. 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!