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					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 middle
  2. 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!

				
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