International Finance

Chapter 5

Part 2: Forecasting Exchange Rates

FORECASTING EXCHANGE RATES

• Why is it important to do so?

THREE APPROACHES TO FORECASTING

• 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 a couple

of years)– Parity models: long term (2 years plus)

EFFICIENT MARKETS 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.

EFFICIENT MARKETS FORECASTING

• Future spot rates are assumed to be independent of past rates.– “Random Walk.”

• What do we use to forecast?– The current spot rate or – The current forward rate.

EFFICIENT MARKET SUMMARY

• Benefits:– Easy to use.– Costless (spot and forwards are public rates).

• Disadvantages:– Only way to beat the market is if you have

“insider” information.

• May be useful for short term periods!!

TECHNICAL ANALYSIS

• Examines past price data to identify “patterns.”– Relies on charts!

• Patterns can be used to signal future moves in rates.– Suggests that prices are not random!– Method at odds with efficient market

approach.

TECHNICAL ANALYSIS

• Market Momentum – Examine past charts to identify if market

momentum exists.• Last two years, last 3 months, last month• Compare daily moves to trend• Examine extremes

– What is the trend in market momentum?

• Use UBC web-site to chart data.– http://fx.sauder.ubc.ca/

EURO: LAST 2 YEARS

EURO: PAST 91 DAYS

EURO: PAST MONTH

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 current spot 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.

SPOT TO 90 DAY MOVING AVERAGE

BOLLINGER BANDS

• Bollinger Bands:– Allows for comparison of volatility 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.

1. A simple moving average (SMA) in the middle2. An upper band (SMA plus 2 standard deviations)3. A lower band (SMA minus 2 standard deviations)

• Standard deviation is a statistical term that provides an indication of the currency’s volatility.

INTERPRETATION OF BOLLINGER BANDS

• Bollinger Bands are designed to capture the majority of a currency’s price movement. – When prices move above the upper band,

they are considered high (overbought) on a relative basis.

• Signal of future weakness in currency

– When prices move below the lower band, they are considered low (oversold) on a relative basis.

• Signal of future strength in currency

BOLLINGER BANDS: 90 DAY AVERAGE (GREEN LINE)

FUNDAMENTAL ANALYSIS

• What are the relative economic forces that drive the spot exchange rate?

• Non-Parity Models:– Assets Choice Model– Balance of Payments Model

• Both combined with “government intervention activity.”• Both combined with “country risk assessment.”

• Parity Models– Purchasing Power Parity– International Fisher Effect

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 foreign currency.– Increase in demand will cause the currency to

strengthen.– Decrease in demand will cause the currency

to weaken.

ASSET CHOICE VARIABLES

• Relative Interest Rates– Countries with relatively higher short term interest

rates will experience increased short term capital inflows.

– Inflows of short term capital will strengthen a currency.

• Examine current short term interest rates in the two countries

• Assess the likelihood of changes in short term interest rates in both countries

CURRENT SHORT TERM INTEREST RATES

• Use Bloomberg or the Economist (or other sources) for current short term interest rates.– http://www.bloomberg.com/markets/rates/inde

x.html– http://www.economist.com/

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.– Central bank actions.

• Need to assess both of these.• Also look at yield curves to market’s expectation

regarding future moves in short term rates.

CENTRAL BANK ANNOUNCEMENTS

• Visit the web sites of central banks for latest announcements and past decisions.

• http://www.bis.org/cb/index.htm

OTHER POSSIBLE SHORT TERM ASSET CHOICE FACTORS

• Equity Market Performance– Strong equity markets will also pull in capital

from foreign investors– Capital inflows will strengthen a currency.

• Assess recent moves in equity markets.

• What is the outlook for equity markets over the period of the forecast?

GOVERNMENT INTERVENTION POLICIES

• Governments occasionally intervene in foreign exchange markets to support their currency.– Selling a strengthen currency– Buying a weakening currency

• Government intervention can affect the exchange rate and hence the error of the forecast.

GOVERNMENT INTERVENTION

• Need to assess the likelihood of government intervention during the period of the forecast.

• Some central banks are much more prone to use intervention.

COUNTRY RISK ASSESSMENT

• Generally speaking, markets tend to discount high risk environments.– Tends to weaken a currency

• Need to assess country risk– Political and economic risk factors.

• One source of country risk is Institutional Investor Magazine.

• Another source, relating to corruption, is Transparency International.

SOURCES OF DATA

• http://www.transparency.org/– Go to “Corruption Surveys.”

• Institutional Investor Magazine– In Business School Library

BALANCE OF PAYMENTS MODEL

• Examine a country’s balance of payments 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.

PARITY MODELS

• Purchasing Power Parity Model– Use absolute PPP 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.– The Economist Magazine as one source.

• “Economic and Financial Indicators section.”

PARITY MODELS

• 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

SOURCE OF MARKET INTEREST RATE DATA

• Bloomberg

• The Economist Magazine• Economic and Financial Indicators section.”

• Make sure the maturity of the securities matches the time period of the forecast!