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International Finance by yurtgc548

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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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