Part III

Exchange Rate Risk Management

Information on existing Information on existing
and anticipated and anticipated
economic conditions of cash flows in
various countries and each currency
on historical exchange at each subsidiary
rate movements

Forecasting Measuring
exchange exposure to
rates exchange rate
Managing fluctuations
exposure to
exchange rate
fluctuations
 Forecasting Exchange Rates

South-Western/Thomson Learning © 2003

 Chapter Objectives

• To explain how firms can benefit from

forecasting exchange rates;
• To describe the common techniques used
for forecasting; and
• To explain how forecasting performance
can be evaluated.
 Why Firms Forecast
Exchange Rates
• MNCs need exchange rate forecasts for
their:
¤ hedging decisions,
¤ short-term financing decisions,
¤ short-term investment decisions,
¤ capital budgeting decisions,
¤ long-term financing decisions, and
¤ earnings assessment.
 Forecasting Techniques

• The numerous methods available for

forecasting exchange rates can be
categorized into four general groups:
 technical,
 fundamental,
 market-based,and
 mixed.
 Technical Forecasting

• Technical forecasting involves the use of

historical data to predict future values. It
includes statistical analysis and time series
models.
• Speculators may find the models useful for
predicting day-to-day movements.
• However, since they typically focus on the
near future and rarely provide point/range
estimates, they are of limited use to MNCs.
 Fundamental Forecasting

• Fundamental forecasting is based on the

fundamental relationships between economic
variables and exchange rates.
• A forecast may arise simply from a subjective
assessment of the factors that affect
exchange rates.
• A forecast may be based on quantitative
measurements (with the aid of regression
models and sensitivity analysis) too.
 Fundamental Forecasting

• Known relationships like the PPP can be

used for the regression models. However,
problems may arise. In the case of PPP:
¤ the timing of the impact of inflation on trade
behavior is not known for sure,
¤ prices may be measured inaccurately,
¤ trade barriers may disrupt the trade patterns
that should emerge, and
¤ other influential factors may exist.
 Fundamental Forecasting

• In general, fundamental forecasting is limited

by :
¤ the uncertain timing of the impact of the factors,
¤ the need for forecasts for factors with
instantaneous impact,
¤ the possibility that other relevant factors may be
omitted from the model, and
¤ changes in the sensitivity of currency
movements to each factor over time.
Market-Based Forecasting

• Market-based forecasting involves

developing forecasts from market
indicators.
• Usually, either the spot rate or the forward
rate is used, since speculation should
push the rates to the level that reflect the
market expectation of the future exchange
rate.
Market-Based Forecasting

• Since forward contracts have low trading

volumes and are not widely quoted, the
interest rates on risk-free instruments can
be used to determine what the forward
rates should be according to IRP for long-
term forecasting.
 Mixed Forecasting

• Mixed forecasting refers to the use of a

combination of forecasting techniques.
• The actual forecast is a weighted average
of the various forecasts developed.
 Online Application

• Visit http://www.yardeni.com for reviews of

international political and economic
events and their presumed global impact.
The site also presents economic and
political analyses of major economies.
• Country outlooks and exchange rate
forecasts can also be found at
http://biz.yahoo.com/ifc/.
 Forecasting Services

• The corporate need to forecast currency

values has prompted some consulting
firms and investment banks to offer
forecasting services.
• Advice on hedging and international cash
management, and assessment of the
firm’s exposure to exchange rate risk, may
be provided too.
 Forecasting Services

• One way to determine whether a

forecasting service is valuable is to
compare the accuracy of its forecasts with
the accuracy of publicly available and free
forecasts.
Evaluation of Forecast Performance

• An MNC that forecasts exchange rates

should monitor its performance over time
to determine whether its forecasting
procedure is satisfactory.
• The MNC may also want to compare the
various forecasting methods.
Evaluation of Forecast Performance

• One measure of forecast performance is the

absolute forecast error as a percentage of
the realized value:
| forecasted value – realized value |
realized value
• Over time, MNCs are likely to have more
confidence in their forecasts when they
know the mean error for their past forecasts.
 Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
Absolute Forecast Error ($)

0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
1975 1980 1985 1990 1995 2000
Evaluation of Forecast Performance

• The ability to forecast currency values

may vary with the currency of concern.
• In particular, the value of a less volatile
currency is likely to be forecasted more
accurately.
Evaluation of Forecast Performance

Mean Absolute Forecast Error

Currency as a Percent of the Realized Value
1974-1998 1974-1984 1985-1998
British pound 4.61 % 5.06 % 4.21 %
Canadian dollar 1.73 1.70 1.75
Japanese yen 5.60 5.22 5.93
Swiss franc 5.69 5.81 5.58
 Forecast Bias

• If the forecast errors are consistently

positive or negative over time, then there
is a bias in the forecasting procedure.
 Forecast Bias
Using the Forward Rate as a Forecast for the British Pound

$2.60
$2.40
Forward Rate
$2.20
$2.00
$1.80
$1.60
$1.40 Realized
$1.20 Spot Rate
$1.00
1975 1980 1985 1990 1995 2000
 Forecast Bias

• The following regression model can be

used to test for forecast bias:
realized = a0 + a1  forecast + 
• If a predictor is found to be biased, the
estimated a0 and a1 values can be used to
correct the systematic error.
Graphic Evaluation of Forecast Performance
z
Region of Perfect
downward bias
forecast
(underestimating)
Realized Value

line

Region of
upward bias
(overestimating)
x

x z
Predicted Value
Graphic Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound

$2.50 Perfect
Forecast
Realized Spot Rate

Line
$2.00

$1.50

$1.00
$1.00 $1.50 $2.00 $2.50
Forecast (Forward Rate)
 Graphic Evaluation
of Forecast Performance
• If 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.
 Comparison of
Forecasting Techniques
• The different forecasting techniques can
be evaluated
¤ graphically - by comparing the distances
from the perfect forecast line, or
¤ statistically - by computing the mean of the
absolute forecast errors, and then using a t-
test or a nonparametric test to determine
whether there is a significant difference in
the accuracy of the forecasting techniques.
Forecasting Under Market Efficiency

• If 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.
Forecasting Under Market Efficiency

• 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 Efficiency

• Nevertheless, 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.
 Exchange Rate Volatility

• MNCs also forecast exchange rate

volatility. This enables them to specify a
range (confidence interval) and develop
best-case and worst-case scenarios along
with their point estimate forecasts.
• Popular methods for forecasting volatility
include:
 the use of recent exchange rate volatility,
 Exchange Rate Volatility

 the use of a historical time series of

volatilities (there may be a pattern in how
the exchange rate volatility changes over
time), and
 the derivation of the exchange rate’s
implied standard deviation from the
currency option pricing model.
 Online Application

• Various foreign exchange resources,

including exchange rate volatility based
on historical exchange rate movements,
can be found at http://www.oanda.com and
http://pacific.commerce.ubc.ca/xr/.
Application of Exchange Rate Forecasting
to the Asian Crisis
• Before the crisis, the spot rate served as a
reasonable predictor, because the central
banks were maintaining a somewhat stable
value for their respective currencies.
• But even after the crisis began, it is unlikely
that the degree of depreciation could have
been accurately predicted by the usual
models.
Application of Exchange Rate Forecasting
to the Asian Crisis
• The large amount of foreign investment and
the fear of a massive selloff of the
currencies played key roles in the sharp
decline of the Asian currency values.
• However, these two factors cannot be easily
incorporated into a fundamental forecasting
model in a manner that will precisely identify
the timing and magnitude of currency
depreciation.
Impact of Forecasted Exchange Rates
on an MNC’s Value
Technical Forecasting
Fundamental Forecasting
Market-based Forecasting
Mixed Forecasting

m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t ) = expected cash flows in
currency j to be received by the U.S. parent at
the end of period t
E (ERj,t ) = expected exchange rate at
which currency j can be converted to dollars at