International Financial Management

Abridged 10th Edition

by Jeff Madura

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 9
Forecasting Exchange Rates

Chapter Objectives
This chapter will:

A. Explain how firms can benefit from forecasting exchange

rates

B. Describe the common techniques used for forecasting

C. Explain how forecasting performance can be evaluated

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 Why Firms Forecast Exchange Rates

1. Hedging decisions
2. Short-term investment decisions
3. Capital budgeting decisions
4. Earnings assessment
5. Long-term financing decisions

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 Forecasting Techniques

1. Technical Forecasting
2. Fundamental Forecasting
3. Market-Based Forecasting

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 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

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Fundamental Forecasting

1. Based on fundamental relationships between

economic variables and exchange rates
2. Use of sensitivity analysis to account for uncertainty
by considering more than one possible outcome.
3. Use of PPP for fundamental analysis by forecasting
inflation rate differentials
4. Limitations of fundamental forecasting include:
a. Unknown timing of the impact of some factors
b. Forecasts of some factors may be difficult to obtain
c. Some factors are not easily quantified
d. Regression coefficients may not remain constant

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Market-Based Forecasting

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

2. Use of the forward rate to forecast the future spot rate
E ( e) = p
E ( e) = F ( S )− 1
where
E(e) = expected percentage change in the exchange rate
p = percentage by which the forward rate (F)
exceeds the spot rate (S)

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Mixed Forecasting

1. Use a a combination of forecasting techniques

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

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Forecast Error

1. Measurement of forecast error

a. Absolute forecast error as a percentage of the realized value
= (forecasted value – realized value) / realized value
2. Forecast error among time horizons
3. Forecast error over time periods
4. Forecast errors among currencies
5. Forecast bias

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Statistical Test of Forecast Bias

St = a0 + a1 Ft −1 + t
where
St = spot rate at time t
Ft −1 = forward rate at time t - 1
 t = error term
a0 = intercept
a1 = regression coefficien t

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 Exhibit 9.6 Graphic Evaluation of Forecast
Performance

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Forecasting under Market Efficiency

1. Weak-form efficiency: historical and current

exchange rate information is already reflected in
today’s exchange rate and is not useful for
forecasting.
2. Semistrong-form efficiency: all relevant public
information is already reflected in today’s exchange
rate.
3. Strong-form efficiency: all relevant public and private
information is already reflected in today’s exchange
rate.

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Methods of Forecasting Exchange Rate
Volatility
1. Use of recent volatility level
2. Use of historical pattern of volatilities
3. Implied standard deviation

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.