International Finance
Forecasting Exchange Rates
Bill Reese
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Learning Objectives
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In this unit we will learn:
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Why it is helpful for financial managers to be able
to forecast changes in exchange rates
Some methods that can be used to try to predict
future changes in exchange rates
How to measure forecast errors
Why Firms Forecast XRs
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Hedging decisions
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Hedging payables and receivables
Short-term financing decisions
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Which currency to borrow in
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Low rate, weakening currency
Why Firms Forecast XRs
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Short-term investment decisions
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Which currency to park money in
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High rate, strengthening currency
Why Firms Forecast XRs
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Capital budgeting decisions
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Analysis includes currency conversions for future
cash flows
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Must assume an XR
Why Firms Forecast XRs
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Earnings assessments
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Should foreign subsidiary remit earnings to
parent, or reinvest in foreign country?
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Remit if foreign currency is expected to depreciate
Why Firms Forecast XRs
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Long-term financing decisions
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Currency of coupon payments for bonds
Dual currency bonds
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Coupon payments in different currency from face value
Forecasting Techniques
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Technical Forecasting
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Use of historical XR data
Looks for trends
Tends to focus on near-term future
Not very precise
Patterns may disappear
Forecasting Techniques
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Fundamental Forecasting
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Based on relationships between economic
variables and XRs
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Inflation rates
Interest rates
Income levels
Government controls
Forecasting Techniques
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Fundamental Forecasting
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Forecasters study fundamentals of economy to
predict economic trends
Plot how past econ events impacted XRs
Use linear regression to forecast
Forecasting Techniques
Purchasing Power Parity
(1 + ΠD) = St+1 = 1+ΔSD/F
(1 + ΠF)
St
Inflation expectations can come from TIPS
vs. T-notes
Not always accurate
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Forecasting Techniques
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Forward Rates
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Market-based forecast
Must account for bid-ask spread (can be wide)
Has been more accurate in recent years
Forecasting Techniques
Example: $/£
Forecasting Techniques
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Today’s Spot Rate
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Expectations already built into spot rate
Best for short-term forecasting
Relies on notion of market efficiency
Forecasting Techniques
with Mexican Peso
Forecast Error
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Always will have some error
Potential error is larger for
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More volatile currencies
Longer forecast horizon
How Forecast Error is Affected by Volatility
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Forecast Error
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Forecast error can have severe
consequences for MNC
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Can turn positive NPV project into negative NPV
project
MNC may choose to hedge
Forecast Error
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Measuring forecast error
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As percentage of realized value
Difference between
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Error =
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Forecasted & Realized
Value
Value
Realized Value
Forecast Error Example
Forecasted
Value
Realized
Value
British Pound
$1.35
$1.50
Mexican Peso
$.12
$.10
British Pound
Mexican Peso
1.50 - 1.35 = 10% .12 - .10 =20%
1.50
.10
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Types of Forecast Errors
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Inaccurate but unbiased
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Biased
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Low r2
Large but random forecast errors
Predictable forecast errors
Forecast Error Example
Forecast Error Example