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International Financial Management 11th Edition

by Jeff Madura

Part 3 Exchange Rate Risk Management

9 Forecasting Exchange Rates

 Explain how firms can benefit from forecasting exchange rates

 Describe the common techniques used for forecasting

 Explain how forecasting performance can be evaluated

 explain how interval forecasts can be applied

Chapter Objectives

Why Firms Forecast Exchange Rates

1. Hedging decisionsWhether a firm hedges may be determined by its forecasts of foreign currency values.

2. Short-term investment decisionsCorporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies.

3. Capital budgeting decisionsWhen an MNC’s 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.

Why Firms Forecast Exchange Rates (Cont.)

4. Earnings assessmentThe 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.

5. Long-term financing decisionsMNCs that issue bonds to secure long-term funds may consider denominating the bonds in foreign currencies.

Exhibit 9.1 Corporate Motives for Forecasting Exchange Rates

Forecasting Techniques

1. Technical Forecasting

2. Fundamental Forecasting

3. Market-Based Forecasting

Technical Forecasting

1. Involves the use of historical exchange rate data to predict future values

2. Limitations of technical forecasting:a. Focuses on the near future

b. Rarely provides point estimates or range of possible future values

c. Technical forecasting model that worked well in one period may not work well in another

Fundamental Forecasting

1. Based on fundamental relationships between economic variables and exchange rates

2. Use of sensitivity analysis Considers more than one possible outcome for the factors exhibiting uncertainty.

3. Use of PPPWhile the inflation differential by itself is not sufficient to accurately forecast exchange rate movements, it should be included in any fundamental forecasting model.

4. Limitations of fundamental forecasting include:a. Unknown timing of the impact of some factorsb. Forecasts of some factors may be difficult to obtainc. Some factors are not easily quantifiedd. Regression coefficients may not remain constant

Market-Based Forecasting

 Use of the spot rate to forecast the future spot rate.

 Use of the forward rate to forecast the future spot rate.

 The forward rate should serve as a reasonable forecast for the future spot rate because otherwise speculators would trade forward contracts (or futures contracts) to capitalize on the difference between the forward rate and the expected future spot rate.

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Market-Based Forecasting (Cont.)

 Long-Term Forecasting with Forward RatesLong-term exchange rate forecasts can be derived from long-term forward rates. Like any method of forecasting exchange rates, the forward rate is typically more accurate when forecasting exchange rates for short-term horizons than for long-term horizons.

 Implications of the IFE for ForecastsSince the forward rate captures the interest rate differential (and therefore the expected inflation rate differential) between two countries, it should provide more accurate forecasts for currencies in high-inflation countries than the spot rate.

Mixed Forecasting

 Use a combination of forecasting techniques. (Exhibit 9.2)

 Mixed forecast is then a weighted average of the various forecasts developed.

 Guidelines for Implementing a Forecast All managers of an MNC should rely on the same exchange

rate forecasts.

 MNCs may complement their forecast by hiring forecasting services to obtain exchange rate forecasts.

Exhibit 9.2 Forecasts of the Mexican Peso Drawn from Each Forecasting Technique

Forecast Error

Measurement of forecast errorAbsolute forecast error as a percentage of the realized value = (forecasted value – realized value) / realized value

Forecast error among time horizonsThe potential forecast error for a particular currency depends on the forecast horizon.

Forecast error over time periods

The forecast error for a given currency changes over time.

Forecast errors among currencies The ability to forecast currency values may vary with the currency of concern.

Forecast biasWhen a forecast error is measured as the forecasted value minus the realized value, negative errors indicate underestimating, while positive errors indicate overestimating.

SUMMARY

 Multinational corporations need exchange rate forecasts to make decisions on hedging payables and receivables, short-term financing and investment, capital budgeting, and long-term financing.

 The most common forecasting techniques can be classified as (1) technical, (2) fundamental, (3) market based, and (4) mixed. Each technique has limitations, and the quality of the forecasts produced varies. Yet due to the high variability in exchange rates, each technique has limited accuracy.

SUMMARY (Cont.)

 Forecasting methods can be evaluated by comparing the actual values of currencies to the values predicted by the forecasting method. To be meaningful, this comparison should be conducted over several periods. Two criteria used to evaluate performance of a forecast method are bias and accuracy. When comparing the accuracy of forecasts for two currencies, the absolute forecast error should be divided by the realized value of the currency to control for differences in the relative values of currencies.