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International Financial Management: INBU 4200 Fall Semester 2004 Lecture 5: Part 1 Forecasting Exchange Rates Forecasting Exchange Rates • Why is it important to do so? – So that business firms can assess their foreign exchange exposures. • Currencies they are dealing and the potential for the exchange rate to move against them. – So that business firms can manage their identified exposures. • Where they identify the potential for “large negative” exposures, they can take steps to cover (hedge, or protect themselves). Forecasting Approaches • 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 about a year) – Parity models: long term (beyond one year) Efficient Market 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. • No way to predict future spot rates. Efficient Market Forecasting • Future spot rates are assumed to be independent of past rates. – “Random Walk.” • What can we use to forecast? – The current spot rate or – The current forward rate. Efficient Markets Summary • Benefits: – Easy to use. – Costless (spot and forwards are public rates; observable). • Disadvantages: – Only way to beat (“do better than”) the market is if you have “insider” information. • Approach may be useful for relatively short term periods (out to a couple of months). – Also depends upon the exchange rate regime. Technical Analysis • Examines past price data in an attempt to identify “patterns.” – Patterns with regard to prices (and perhaps volume). – Relies on charts! • Patterns can be used to signal future moves in rates. – Assumes historical patterns will “repeat” themselves and thus are useful in predicting future moves in exchange rates. – Suggests that prices are not random! – Method at odds with efficient market approach. Technical Analysis Approaches • Market Momentum – Examine past charts to identify if market momentum exists. • Has the currency exhibited historical strength or weakness? • Look at last two years, last 3 months, last month. • Compare daily moves to longer term trend. • Examine historical extremes in rates. – Based upon the above, what is the “anticipated” trend in market momentum? • Will current strength or weakness continue, or • Will current strength or weakness reverse? • Recommendation: use web-sites to chart data. – http://fx.sauder.ubc.ca/ Canadian Dollar (CAD): Last 2 Years • What has been the 2 year trend? Canadian Dollar (CAD): Last 91 Days • What has been the 3 month trend? Canadian Dollar (CAD): Last 31 Days • What has been the 1 month trend? 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. • Present chart so that it “correctly” shows currency strength or weakness. – Relate to quote: Is it American or European terms? Spot to 90-day Moving Average • Note: Scale has been inverted to show trend (CAD is European terms quoted currency) • What does this chart suggest? Bollinger Band Indicator Analysis • Bollinger Band Analysis: – 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 over some past period of time. These are: 1. A simple moving average of the spot rates (SMA) in the middle of the band. 2. An upper band of the spot rates (SMA plus 2 standard deviations) 3. A lower band of the spot rates (SMA minus 2 standard deviations) • Standard deviation is a statistical term that provides an indication of the currency’s volatility. Interpretation of Bollinger Band Indicators • Assumption: Bollinger Bands are assumed to capture the majority of a currency’s price movement. – When prices move above the upper band (SMA plus 2 standard deviations), currencies are considered overbought (and thus spot prices are high). • Signal of future weakness in currency – When prices move below the lower band (SMA minus 2 standard deviations) currencies are considered oversold (and thus spot prices are low). • Signal of future strength in currency Bollinger Bands (90-day Average Green Line) • Look at current and historical signals. Fundamental Analysis • Focus: What are the relative economic forces that may drive the spot exchange rate in the future? • Non-Parity Models: – Assets Choice Model • Why do foreign exchange markets desire to hold one currency over another? – Balance of Payments Model • How do balance of payments accounts affect the exchange rate? • 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 currency. – Increase in demand will cause the currency’s spot rate to strengthen. – Decrease in demand will cause the currency’s spot rate to weaken. Asset Choice Variables • Relative Interest Rates – Countries with relatively higher short term interest rates will experience increased short term capital inflows. – Thus, demand for the currency increases. – Inflows of short term capital, resulting in demand increases, will strengthen a currency’s spot rate. • Examine current short term interest rates in the two countries. – Look at relative rates. • Also assess the potential for changes in short term interest rates (and thus, changes in the interest rate differential) in both countries. – Which country appears to be the most attractive for short term investing. Interest Rate Data • 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. • Based on the pro-cyclical nature of interest rates. – Central bank interest rate decisions. • Need to assess both of these. • Also look at yield curves to market’s expectation regarding future moves in short term rates. Where to View Central Bank Decisions and Announcements • Visit the web sites of central banks for latest announcements and past decisions. • http://www.bis.org/cb/index.htm Additional Asset Choice Variables • Equity Market Performance – Strong equity markets will also pull in capital from foreign investors. – This results in an increase in the demand for a currency. – Thus, capital inflows, resulting from equity market performance, will strengthen a currency. • Assess recent moves in major equity markets. • What is the outlook for equity markets over the period of the forecast? Government Intervention Policies • Governments may intervene in foreign exchange markets to support their currency. • Depends upon the foreign exchange regime. • Government actions take the form of: – Selling a strengthen currency (increasing supply) – Buying a weakening currency (increasing demand) • Government intervention can affect the spot exchange rate. • Why important? – May offset initial your forecast for the currency. Country Risk Assessment • Generally speaking, markets tend to discount the currencies of “high risk environments.” – Markets reluctant to hold these currencies. – Tends to weaken a currency • Thus we need to assess country risk – A country’s unique 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.” – Indication of “Political” environment situation. • Institutional Investor Magazine – In Business School Library Balance of Payments Model • Examine a country’s balance of payments accounts 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. – High (trade and current account) surplus countries are already pulling in foreign capital • Tends to put upward pressure on the exchange rate of these countries. Parity Models: Review • Purchasing Power Parity Model – Use absolute PPP model 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. – Relative PPP model – The Economist Magazine as one source of expected inflation. • “Economic and Financial Indicators section.” Parity Models: Review • 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. – Note: This parity model’s assumption about the relationship of interest rates to exchange rates is opposite to the asset choice model. Sources of Market Interest Rate Data • Bloomberg • The Economist Magazine • Economic and Financial Indicators section.” • Important: – Make sure the maturity of the securities you are selecting matches the time period of the forecast!
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