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!