CHAPTER OVERVIEW

FORECASTING EXCHANGE RATE

SCOPE OF PRESENTATION

ARBITRAGE AND THE LAW OF ONE PRICEPURCHASING POWER PARITYTHE FISHER EFFECTTHE INTERNATIONAL FISHER EFFECTAPPROACHS FOR CURRENCY FORECASTINGCURRENCY FORECASTING

FIVE KEY THEORETICAL RELATIONSHIPS D%EFORWARDDISCOUNT ORPREMIUMINTEREST RATE DIFFERENTIALEXPECTEDINFLATIONDIFFERENTIALIFEFEIRPUFRPPP ARBITRAGE AND THE LAW OF ONE PRICETHE LAW OF ONE PRICE Identical goods sell for the same price worldwide. If the prices after exchange-rate adjustment were not equal, arbitrage of the goods ensures eventually they will be so worldwide.

ARBITRAGE AND THE LAW OF ONE PRICE Five Parity Conditions Result From These Arbitrage Activities

Purchasing Power Parity (PPP)The Fisher Effect (FE)The International Fisher Effect (IFE)Interest Rate Parity (IRP)Unbiased Forward Rate (UFR) ARBITRAGE AND THE LAW OF ONE PRICE Five Parity Conditions Linked byThe adjustment of various rates and prices to inflation.

The notion that money should have no effect on real variables (since they have been adjusted for price changes).ARBITRAGE AND THE LAW OF ONE PRICE Inflation And Home Currency Depreciation:Jointly Determined By The Growth Of Domestic Money Supply;Relative To The Growth Of Domestic Money Demand. The Law Of One Price- Enforced By International Arbitrage.

PURHASING POWER PARITYPurchasing Power Parity (PPP) When a countrys inflation rate rises relative to that of another country, decreased exports and increased imports depress the high-inflation countrys currency. Purchasing power parity (PPP) theory attempts to quantify this inflation exchange rate relationship.

PPP: Interpreting The absolute form of PPP is an extension of the law of one price. It suggests that the prices of the same products in different countries should be equal when measured in a common currency. The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar.

PPP Theory: RationaleSuppose U.S. inflation > U.K. inflation. U.S. imports from U.K. and U.S. exports to U.K.Upward pressure is placed on the .This shift in consumption and the s appreciation will continue untilin the U.S.: priceU.K. goods priceU.S. goodsin the U.K.: priceU.S. goods priceU.K. goods

Simplified PPP RelationshipWhen the inflation differential is small, the PPP relationship can be simplified as ef Ih If

Example:Suppose IU.S. = 9% and IU.K. = 5% . Then eU.K. 9 5 = 4%U.S. consumers: PU.S. = IU.S. = 9% PU.K. = IU.K. + eU.K. = 9%U.K. consumers: PU.K. = IU.K. = 5% PU.S. = IU.S. eU.K. = 5%

Purchasing Power Parity: Graphic AnalysisPPP lineInflation Rate Differential (%)home inflation rate foreign inflation rate% D in the foreign currencys spot rate- 2- 42413- 1- 3Increased purchasing power of foreign goodsDecreased purchasing power of foreign goodsABCDPurchasing Power Parity: Graphic AnalysisWhy PPP Does Not OccurPPP does not occur consistently due to:confounding effectsExchange rates are also affected by differences in inflation, interest rates, income levels, government controls and expectations of future rates.a lack of substitutes for some traded goods

PPP in the Long Run PPP can be tested by assessing a real exchange rate over time. The real exchange rate is the actual exchange rate adjusted for inflationary effects in the two countries of concern. If the real exchange rate follows a random walk, it cannot be viewed as being a constant in the long run. Then PPP does not hold.

International Fisher Effect (IFE)International Fisher Effect (IFE)According to the Fisher effect, nominal risk-free interest rates contain a real rate of return and anticipated inflation. If all investors require the same real return, differentials in interest rates may be due to differentials in expected inflation.Recall that PPP theory suggests that exchange rate movements are caused by inflation rate differentials.International Fisher Effect (IFE)The international Fisher effect (IFE) theory suggests that currencies with higher interest rates will depreciate because the higher nominal rates reflect higher expected inflation.Hence, investors hoping to capitalize on a higher foreign interest rate should earn a return no higher than what they would have earned domestically.When the interest rate differential is small, the IFE relationship can be simplified as ef ih _ ifDerivation of the IFE

If the British rate on 6-month deposits were 2% above the U.S. interest rate, the should depreciate by approximately 2% over 6 months. Then U.S. investors would earn about the same return on British deposits as they would on U.S. deposits.Graphic Analysis of the International Fisher EffectIFE lineInterest Rate Differential (%)home interest rate foreign interest rate% D in the foreign currencys spot rate- 2- 42413- 1- 3Lower returns from investing in foreign depositsHigher returns from investing in foreign depositsABCDGraphic Analysis of the IFEThe point of the IFE theory is that if a firm periodically tries to capitalize on higher foreign interest rates, it will achieve a yield that is sometimes above and sometimes below the domestic yield.On average, the yield achieved by the firm would be similar to that achieved by another firm that makes domestic deposits only.Why the IFE Does Not OccurSince the IFE is based on PPP, it will not hold when PPP does not hold.In particular, if there are factors other than inflation that affect exchange rates, exchange rates may not adjust in accordance with the inflation differential.Comparison of the IRP, PPP, and IFE TheoriesExchange RateExpectationsInflation RateDifferentialForward RateDiscount or PremiumInterest RateDifferentialPurchasingPower Parity(PPP)Interest Rate Parity(IRP)FisherEffectInternationalFisher Effect (IFE)Comparison of the IRP, PPP, and IFE TheoriesInterest rate parityForward rate premium pInterest rate differential ih if

Purchasing power parity% in spot exchange rate efInflation rate differential Ih If

International Fisher effect% in spot exchange rate efInterest rate differential ih if

FORECASTING TECHNIQUESCorporate Motives for Forecasting Exchange RatesForecasting exchange rates1QA\Value of the firm1QA\Dollar cash flowsCost of capitalDecide whether to obtain financing in foreign currenciesDecide whether to hedge foreign currency cash flowsDecide whether to invest in foreign projectsDecide whetherforeign subsidiaries should remit earningsForecasting TechniquesThe numerous methods available for forecasting exchange rates can be categorized into four general groups: technical, fundamental, market-based, and mixed.

Technical forecasting involves the use of historical data to predict future values. E.g. time series models.Speculators may find the models useful for predicting day-to-day movements.However, since the models typically focus on the near future and rarely provide point or range estimates, they are of limited use to MNCs.Technical Forecasting

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.Note that the use of PPP to forecast future exchange rates is inadequate since PPP may not hold and future inflation rates are also uncertain.Fundamental Forecasting

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, andchanges in the sensitivity of currency movements to each factor over time.Fundamental Forecasting

Market-based forecasting uses market indicators to develop forecasts. The current spot/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.Market-Based Forecasting

EVALUATIONGraphic Evaluation of Forecast PerformancePerfect forecast linexzxzRealized ValuePredicted ValueRegion of downward bias(underestimation)Region ofupward bias(overestimation)Graphic Evaluationof Forecast PerformanceIf the points appear to be scattered evenly on both sides of the perfect forecast line, then the forecasts are said to be unbiased.Note that a more thorough assessment can be conducted by separating the entire period into subperiods.

Forecast Bias in Different Subperiodsfor the British Pound

Comparison of Forecasting MethodsThe different forecasting methods can be evaluated graphically by visually comparing the deviations from the perfect forecast line, orstatistically by computing the forecast errors for all periods.Forecasting Under Market EfficiencyIf the foreign exchange market is weak-form efficient, then the current exchange rates already reflect historical information. So, technical analysis would not be useful.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.Foreign exchange markets are generally found to be at least semistrong-form efficient.Forecasting Under Market EfficiencyNevertheless, 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.Forecasting Under Market EfficiencyExchange Rate VolatilityA more volatile currency has a larger expected forecast error.MNCs measure and forecast exchange rate volatility so that they canspecify a range (confidence interval) around their point estimate forecasts.

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