Foreign Exchange Risk Exposure and the Forecasting of
Foreign Currency Movements
An Honors Thesis
( ID 499 )
by
Stuart Scott
Thesis Director
Ball State University
~uncie,
Indiana
February 15, 1991
Date of Graduation
May 4. 1991
5CJ;c-"' '
. '
Table of Contents
Defining Foreign Currency Exposure
1
Managing Foreign Exchange Risk
3
Pricing and Inventory Strategies
5
Leads and Lags
6
Inter - Company Accounts Adjustments
8
Debt and Working Capital
9
Inter - Currency Setting
10
Forward Exchange Contracts
11
Foreign Exchange Risk and Forecasting of Exchange Rates
12
How Foreign Currency Forecasts Are Made
13
Accuracy of Currency Forecasts
14
Evaluation of Forecasting Accuracy
14
Summary
18
~otes
21
Appendix 1
23
Appendix 2
24
Appendix 3
25
Appendix 4
26
Appendix 5
27
Bibliography
28
Acknowledgments
I would like to thank my mother for her patience and
dedication in typing this paper not once, but twice, because
of a mistake I made on the computer that resulted in the
"agony of delete"
of the first draft. Without her countless
hours of typing and proofreading,
been possible.
this paper would not have
1
Foreign Exchange Risk Exposure and the Forecasting of Foreign
Currency Movements
Defining Foreign Currency Risk Exposure
Todays businesses are facing an expanded global
and
a
proliferation
Foremost
expansion.
of
of
new
alllong
problems
the
foreign exchange risk facing
the
loss
suffered
fluctuations
exchange
risk
corporations
purchasing
exchange
by
the
affects
involved
power
risk
referred
Translations
exposure
currency
paper
foreign
and
stockholders
and
managers
on
the
i )
does
defined
are
to
iii)
are
the
Foreign
costs
analysts
strength of
of its earnings in dollars.
affect
cash
evaluate
a
of
the
deviations
forms
of
from
foreign
i i )
exposure
risk
operational
exposure
exposure).
exposure
translated
the
unfavorable
froU!
that
occurs
its
local
Translation exposure results
not
managers
exposure risk as
and
as
this
freely floating
Economic
as
the
currencies.
three
an accounting
assets
In a
with
controlling
Translation
to
is
is
due
revenues
There
facing
looks at
foreign
is
exposure
into dollars.
losses
and
exposure:
(sometimes
the
of
the
parity.
risk
their MNCs
corporations
value
Transaction
when
-
in
(MNCs)
This paper
world monetary system.
-
problems
Corporations
Multinational
associated
economy
flows,
however.
corporation
the balance sheet
in only
and
many
its
and stability
Translation exposure can have an
effect on earnings that cannot be ignored.
-
2
Transaction
exchange
have on
that
effect
changes
in
the dollar
revenue
received on sales
denominated in foreign currencies.
Changes
in exchange rates
have
rates
the
is
exposure
quantifiable
impacts
on dollar
costs
and
revenues
from
the expenses and sales denominated in foreign currencies.
Economic exposure
exposure}
is
the
{sometimes
undermining of
referred
a MNC
to as
to price
operational
its
products
competitively while maintaining an acceptable profit margin.
This
is
caused
economic
sold
in
by
exposure
are
incurred.
\.:.s.
firm
The
first
M~Cs
~.s.
is
revenues
factor
products
of
being
denominated
In
than the currenc.y in which production costs
The
This
to
generate
that
second
recog'nized even where
revenues.
factors.
important
markets
currencies other
several
factor
there
is
against
operational
risk
no mismatch between costs and
IS
second factor arises
competing
the
a
from the situation of a
market
leader
whose
costs
are
incurred in a currency other than the currency of the country
to which they
up
against
currency.
MXC were
market
a
export.
market
-.
price
For example,
to
appreciate
leader,
the
return on sales or
export
In this
t
and
risk
~.s.
situation a
set
b,Y
~.s.
reference
to
another
if the cost based currency for a C.S.
against
the
cost
corporation
based
would
market
Economic exposure can affect
share
to
currenc.y of a
face
they would have to raise
losing
producer IS
the
a
declining·
the price of
market
the
leader.
even purely domestic businesses
which compete with foreign MNCs in the C.S. market.
Economic
exposure is a serious concern to MNCs because it affects cash
,-
3
flows.
When dealing with foreign currency exposure,
first
deGide
currenc,y
exposure
uiversif.y
stocks;
its
whether
at
ag'ainst
thereby
foreign
it
will
exchange
arg'ue
risks
by
the
need
eliminating-
exchange
undertake manag'ing'
Some
all.
rebutted by experts who claim that
the
\C'C
to
manage
their
that
for
foreign
it
a
foreign
can
portfolio
\1~C
the
t his
its
slockholders
holding;
Howe v e r ,
risk.
an \E\C mLlst
to
a r g um e u t
manag-e
has
bee n
is more economical
exchang-e
rb;k
of
becallse
for
M:\Cs
have superior knowledge and facility resulting ill lower costs
of
--
defense
against
foreig-n
currency
exchange
risks
than
do
individual stockholders.
Managing- Foreign Exchange Risk
Assuming
an
M~C
has
taken
own foreign exchange risk,
will
manage
its
centralizing
for
1 al'ge r
the
uecentralized
allow
each
be
relatively
are easJ
its
sole
negative
Lo
which
of
subsidiar.y
prof i tabi 1 i t;y.
at
do
Implementing
easy because
isolal~.2
emphasis
effects
011
the
of
managing
the
all
it
feels
of
or
subsidiary
the parent
if
it
else
compan.Y·
best
risk
for
a
A
would
its
managemenl
own
would
exposure mallagement
Decentralizeu exposure managemenl,
011
its
bubsidiaries
exchange
decentralized
costs
lll~
parent
foreign
what
the
,
,
Level
subsidiary
of
managing
to
task
coordinates
interests
form
the
the corporation must decide
exposure
systelll
on
performance,
may
with
have
company_ With each subsidiar.y
controlling
be
its
exposure management
inefficiencies
in
hedging
independentl;y
decisions
when
another
position
it
benefit
uf
an open posi tion
subsidiary
wishes
the
may
to hedge
parenl
have
and
company
to
an
the
prote:..:t
exacll;'\'
correct
would
be
from
the
subsidiar~
a
its ear"1l111g-s
uppusite
opeu
the
tlec.i:;.ion fo.'
Lo
not
have
either
the couIllerbalancing- effecl of
due
each open position. For
this reason a centralized approach
major'
foreig-n
advantage
exchange
legal
exchang"e
uf
exposure
transaction
and
a
to
is
recommeudeu
cent.ralized melhod
is
1" f~
that
exposure
iulo
one
tax entitys with
CelltralizaLion
of
d.
allows
for
of
subsidiaries.
exposure
manag-emelJ l
economies
global
or
of
level.
that
foreign
scale
management
use
fair'l~
risk
examine
r i !'Ill
opportunities
exchange exposure.
f
several
an
to
Lo
reap
at
Ule
net ling
for payments among the
This nelting s.ysteul reduces
the methods
0
Centralized
enables
the float
iu funu.o,
transaction costs. 3
Wit h a c en t r ali zed f r am e w0 r k i n p I ace,
to
for
Cenlralized managemenl uses a currenc.)
as well as bank fees and
foreig'll
and ("!vaJi.latioH over
them.
arbitrage
s,ystelll that acts as a clearing- process
subsidiaries.
versus
allocale costs
incurred
exchang-e
and
The
a c c um u I a t ion
idelitit~
leg-al
J,E'Cs.
to
deceutralized system.
The sy-slem must
subsidiaries
most
handling'
for
:'eq:lires sophisticateJ methods of control
--
\'iill
subsidiary hedg"e at all
manag-ing:
-
to hedge
viewed
For example,
perspective of the par'ent compan;r.
may choose
when
there
a MNC can use
the n ext
Lo reduce
their
s t ep
1 S
foreig'u
-
5
Wheli
COIll~HiH,y
a
fc>r-~ig;!l
their
decide.s
lo,=>se.s
ear!!ing's
a"p
alld
very
favorable effecl
to
important
exposure
defending
agaillst
l'~duce
Lo
its
of
~:;-Cs
(translation,
again::; t.
companies
as::;els
)A~Cs
v.illiug
their
rate
use
they
than
b.y
a.ssels
v;
i l11
defend
ruling
rather
ag·ain.s t
uefelluing
to protect
~XCs
movements.
to
losse::;.
to
risk
uefend
cash
to
(SrillVaS~!l'.l.
The
)AXCs
exposure
to take risk::;
CCish
following-
use
to
Slel:id,)
becau.se
the
of
cash
illS t
against
it
that
p.
al'e
attain
defend
are
defending'
l' ~l111en
at
t::;
1 ike
all.
:::ew
the pressure
invenlory
and
fixed
than historic-I'ale assets.
transaction
the casL
are much more
against
the t,ype
the,}
no t
are
eX20sure
vhlu~'
\\.illiIlg
lu
II!
exchange
jC1s~if.)
transaction/economic
ag'aius l
are
I:. dollar'::; of
lor:.g term cOllll'acls against auverse chang-es
of
firms
lransaclio.:,)
M~Cs
f inu
we
exposure
if
are moneta!',;)
However.
the
vary uepenuing' ...:.pon
economic,
Tlw.s,
contracts.
translation
reduce
earning:::"
accounting slandard (FSAB-52) has helpeu relieve
-
to
the,y have on stock prices.
translatioll
forward
to
strategies
is
stabilize
The strategies useu by
of
emplo,Y
g'oal
its
exposure,
exchang'c
to
translalioll
the
expOSLlre
.. paper
38)
some of
their
lhe specific major
for e ig'u
exchange
slralegies
managemenl
objectives.
All
effeclive
method
for
protecting-
again~il
currellc,j
-
6
devalualiulls
tu
1:0;
it
iY-.lt
which
Cal!
uf
lhis
which
market
;lOt
ill
the market
If
the MXC's
will
simply
price
resistance
increase.
executives
M~C
sc.!.!"veyeu.
their
:J.se
showed
was
thai
illU"eaSlzig
nol
IS
a
thal
the
export
100
tell
prices
TraIl
method
Lo
MXC::;
:'0
lucal
uetermi.;:lt'
that
local
customer
prlce
manag"emeut
!'
eq u ell t
countl"ies.
huw
1 ;yO
Tran
prevalent
lecllldque~;.
Results
strategies
fJ!"lces
with
their use as onlj
revealed
f
used
;.tsed
aut!
lhe
uomeslic
fureig;ll
15
defensive
~l);Cs
if
have
a
develofJing
intersubsidiary pricing of products
the
uf
has
then cuslomers
ma,Y
frulll
t 11 i s
uf
the Pl'Ou.ucL.
prudclct
leCl.uers
\1~Cs
mallJ
the fJl'odu(;t
leader~
market
lhis
different
surveJ'
for
e l' fee t i v e!~ t~ s s
competilion
of companies characLeriL.il1g"
However,
ma!lag"cr::; •
to
competitor's
that
FOl'L.l.ne
export
a
exchang"e
fL.:.cluations
iIUfJussiLle
The
\'iIllt
sur'"e:.,
a J1
ag;ai.!lsL
the price elasticity uf
increCl.sed
of
be
and
lUCh:
IH
large
concern
Even market
revealed
tell
prutecl
agaiust
leaders.
substitute
subsi.dial"ies
Pl'lC';o
the cOlllfJelilive fJo!:;iiiun
011
fJl'oduct
A
cannut
defend
place alld
and.
selling;
strategy lUaJ
increased.
IS
Lhe
hi g."he::; l
the
straiegJ: depend::::;
-
hell->
CnfurilulaLely,
are
up
Tlli::; melhod
expurt markets.
lusses
mark
fur
the majol'it,}
"uceasionally".
increasing"/decreasing"
of
was
of
!.lsed b,Y only half
M~Cs. 4
-Leading
and
,laggl!lg
"
straleg"ies
are
used
Lo
shifl
7
expo~ure
of
curreue,)
depreciat.iIl~;
currencies
receivable
and
particular
curreIlCle~.
OIl
pa,ymellls
lev,yillg
ulOdif,ying:
the
terms
Jll i
i
a
cOlllpan.)
t e tl
modir"
l~;
has
!ll
-
ma,Y
accuLwls
lo
of
aCCOUl:1S
pa,yable
wo,dd be
di
past
fuLl!'\:;
SCOUl'
u-1e
111
to
uffer
ag i ng'
lale
accounls
01'
by
Clearl,Y,
customers.
that
Also.
the
the
n
ucI!
.i l::;elf
ten
abi 1 i
the
mu~l
IV!
thoul
t~
i l
cOllside!'
a
has
vendor
suppl ier
to
and
olh,erwise
practices
corporation::;
of
lhese
revealed
pa.yables
0
S
corporations
half
survey
cor po r ali
to
have
liJ,(il
the'
and/or
a
~hare.
most
However,
1 imi t
can
movemellts.
The competitive slrength
corporaLion
A
CUl'l'CIlC,y
shortcoming'~;
contains
mar'ke l
f 1nd
of
I0) •
lh e
a
resislance
Res~ll::;
lag'
on
extended
strateg'.)-
terlll~.
::,hriI1kiag market
to
uf
while
seam 011 g; cor p 0 rat i 011:::; •
:J
corporation
showed
terms
aIllicipatiol! of
iI!
cletlit
customer
level::,
leading slrateg'y
charges
sl.;ller/bujel'.
the
levels
payments
late
the
this straleg.)' because companies must neg'otiate
lead/lag'
1i
the
the
credi t
lhe succ(:,ss of
The
reducing
to
to predict future currency movements ;;.s vilal for
the abilit,Y
credit
b,y
prompt
a discount
u.)'
fluctuations
increasing'
appli,;.;alion uf
,\Il
--
value
than
lead
wan ted
sale1,
"We
L',y
Lo
means
.)-O'..l
pa.)-
,)0''':'1'
that
do
do
Li:1::,·'.
use
leads
su
only
corporations
receivables
lop l' 0 j e ct.
maintain
survey'ed
a
g'ood
one
l!lIag'e
Over'all,
and
L~
this
lag-s
TraIl
(8
of
"occasionally".
were
because
As
V.inh
b;)
less
oj'
the
likely
iruag'e
corporate officer
the
m<l!'keL
slraleg'y
which
ha:::
!lOt
-
8
been u~etl. exlensivel,}
boY mo~l M~Cs.5
Iuler-Company Accounts Aujus lmenls
Iuler-compau;y
shifting
accouuls
exposure
lhe
aujustmeuis
0 11 e
I 11
are
a
compau.)' wO.lld waul
currencies
E::;seHtially,
is
--
~l:ifling
the
with
lhe
lead~
currency
goal
of
and
of
into
is
critical
to
a
lhi~
subject
which
will
be
currencle::;.
lo
the
adju~lmellls
lo anolher.
accurate
success
of
the
A.:;
foreig'n
intel'-
Forecasting currenCIes
discussed
in
a
later
section of
paper.
M~C's
use
of
iuler-company
wide~pread,
III
lhis
CUl'l'enc,Y
form
of
in leI' - COUlpan,y
fact,
COlllpan,y,
was
found
COlllpallle::;
"usuall,y"
or
ever;YOHe
of
to
dividend
be
used
characlerized
"alwa.)s".
strategy
order
Lo
be
for
the
useful,
len
LIle
adjuslmelll~
~ampled
The
by
lheir
u~e
widespI"eau
half
of
to
of
i.his
lhel'e musl
be
aCCO<1nt~
a
the
lhe
of
the
lhe
parent
sample.
!::draleg.}
acceplance
is due Lo of ils 101'1
illler-compan,),
used
slraleg" ,
remiltance
over
M~\C~
is
One form of
adjuslmenls
company accouHL::; auj.l::;tlllenL::;
In
of
accounL~
exposure lllauag'emelll.
accounls
accelel'aLiIlg)delayiIlg
The
iulo deprecialing
accounls
oblain
company accounLs adjustmenl straLegy.
1S
example,
from one CUrI'enc,>
abilily
loward
direcLion
a
appreciating
iuler-company
eXt>o~ure
lag~,
forecasts
Fo1'
lo ::;hifl ca::;h oulflow::;
inflow::>
and
into
cur !' en c ,Y
consislent wilh exchaug'e rate forecasts.
directed
as
inter-
cosl~.
adjuslmenls
:::lufficienl
amounl
of
9
Also,
inLer-company transactions.
IULer-compan,Y
strateg.>
onl,y
be
M~C::;
.lsed bj!
an,y
of
llllplemeHlalioil
affect
can
local
~::;e
a
remiltance
dividenu
adjusLn:er~t~,
accounts
thal
laws and regulations
sll'aleg',Y
call
centralized forlll of CClrrenc;;
management,
leading'/lag;giue;
are
slrategie.s
acceleraling'/dela,y.iIlg
company,
ano.
divideno.
adjusting
the
ill t er -compaIl,Y
of
forms
major
three
The
pa,yables
dividend
::'ecei vables,
aud
remiltances
parent
the
to
flows
acco;J.I1ls
remilted
to
Lhe
par e!ll cumpali.).!!
straleg.)'
This
cafjital
wilh
of
1 S
regard
tu
foreig;n
buth
Reslruclul'iIlgo
1S
The
of
use
exposure
local
.i
corporations
sampled
managemen t.
Sume
include
bank
that
local
by
Tran
the
foreign
adjustments
inveslmenls,
reduct.iull of
term
liaLilil.ie~,
popular.
used
this
use
uf
currency
to
debL
borrowing'
strategy
and negutialing
of
exposure
'.V
the
lllallagement
capital
prepayment
, . ,
l~
for
exposure
working
compau,)
.short-ler!ll assels
uf
te.u
borrowing,
parent
dictate.
All
and
111
tenu debl.
CUrI'ency
foreigOJl
of
emplu,y
and
very
oS
WUI'l{l!lK
Fur emu s L
domestic,
fOI'eigI~
and
loans,
short
and
, .
and
denominaliull~.
done with both lung; and ::;11u1't
~anagemenl
techniques
currenc,:.
debt
1 1
fU1't:ig;1l.
planned
.s
e
of
.
111C
r eas
C..llort:uc.')
.
l .ag
,
aue.
10
credit swaps.
allow parent
ltaru
rat e
currenC1e::;
!'
their
S.lb,sicliar,y's
the
bu,Ys
engag;lug'
If
c ~':' r en C j- •
subsidial.} '.s
local
in exchang'e for
A
cl'eclil
ug:'ees
a hard C;l!'l'ency
Illler-cul'renc,Y
the
exchang'e
to
anticipation
slniLeg,)
1S
Lo
a
In
net ling
is
risk across
accept
all
that
the
used
tllis
exists
loall
loa!l from
while
currencJ
for
thell
the
.,.ae
sell
[0
a
lra..nsacl.ion is
a
t
credit
lhe
when
subsidiar,y
the parent company.
stcaleg.)
several
'.J[H'!l
position
res:J.lting
los::;
fre<{uelltl,J
\\a.},
expellses with currencies
a
of
diveJ'sif,}illg'
cUl'l'enci/;::s.
!ll
.in
gain
Olle
or
I l
i lUp 1 .i.
currencj-
loss
will
E S
"-11
be
another C;l1'f'ency.7
",itb
exh1ui Led a hig'h ueg'l'ee of correlalio!l
lUovements.
exchange
the pal'elll
cOlliract
swap
lenu
~etli!lg
of.f::;el by all OppoSillg gaUl 01'
Thi::;
forward
Lo
I'ecluced
local
fo!'w&1'd market
baHk
rJ:lcr-Cul'l'enc'}
a willingHess
a
III
no
swap can be emploj-ed.
foreign
al
,
swap occurs WHen
simultaneousl:,'
--
suu:,ddial'ie::;
i s k.
compauj-'
1 0 cal
to
companies
cUl'I'encies
ll~
thal
have
their exchang'e rate
corporation can match revenue
anu
thaL ::;t1'ongly reflecL one anolher in
their currency movements.
Results from
.-.
thal rllne of
the
the
len companies surveyed by Tran inuicaLe
len have usecl this straleg'.}
to some extent •
11
Forward Exchange Contracts
Forward exchange
cover
their
Forward
exchallg"e
of
contracts
-
of
forward
the
contracts,
I'o,)'allies,
lllanag"elllenL
loan
ilems all
lend
lhe
some evidence
OIl
\1XCs
incur
th(:,
Ilolllillal
this
rnalurilie::;,
Also,
high. s
for
::;ome,
offset
and
and
gains
the
Trail
Lu
on
the
losse::;
Oil
reported Hine
leclUlique.
export
paymenls
licensing
Lhemselves
companies
Transaclion hedg"ing,
lhis
oblig"alions,
exchange
concession::;
for
to hedge or
fees,
Paymenls
lransactions,
of
aau
dividends,
off
balance
to forward contract hedging.
use
of
forwal'd
contracts,
there
that forward conlracts llIay be inefficienl al
lrade
reasons
--
L.K.
used
bJ.
producing"
common.
11l1P01'l
widespreau
defending against
of
very
IS
froll!
of
Javaiu
by
Lo currency movements.
repa,ymeul
IS
used
.... hidl
themselves,
arising
Despite
are
losses
lell surveyed companies
receipts
sheet
contracts
transaction
transacliolls due
using"
companies
lhe forward marke t.
against
forwartl
enable
currency positions by purchasing"
exposed foreigIl
a CUI'rency in
hedge
conlracls
revealed
(referred
costs
include
of
lhe
lhat
to
most
a::;
heugiug
the facl::;
ignorance,
costs
A 1984 stud,)' by M.I.
rale risks.
and
of
woulu
opporluuilj
rOleigu
a
of
glve
.lp
cosls)
tha11
CUl'renc.)'.
The
inapPl'opl"iate ll1alchiul;!,
exchange
shorl
ralLel'
lerlU
rale
expeclalions.
bOI'l'o .... illg
",ere
lou
12
Fureig:ll Exchange Risk awl Furecasting of Exehang;e Rates
The abil.ily
tu furecasL
,
,
crUCIal
ehauge
currency manag'emenl program.
planning
a
campau.>
s
LIlt:
currC1!c.)
forecasls
expOS:.lre manag'emenL.
are
in
-
the
developed
Lerms
ke,y
of
and
\~
I 1
C:issess
aCC:.lrac,Y
variables
used
M:;-Cs
use
La
e x am i
the
performance
timeliness.
foreig'H
of
Jl
ra.\'.
,
paper
of
e h0
III
, ,
e x am ill;;';
VY 1 1 1
currenc.)
111 e
for e cas Ls
these
forecas ls
IV
of
addi Lion,
curreuc,J
in
mater'ials
tludr
p1C:i11
a 1S 0
in
success
some
forecas Ling'
of
,
, ,
W1 1 1
be examined.
hu~e
The!'c is a
It
is
estimated
demallu
that
ever.)
least
as
of
other'
well.
the
This
cos L
fu!'
forecasting
annuall".!!
4ue::;L.i.onable
in t e r vie w e u
their
uusiuesse::;
may
SOllie
be
The
GOO
FOI'tune
compau.)
can
~
services.
foreca.stiug
need' scapegoats' Lo puint
boards
::;erVlces.
when
Top
(;u::;t
in
exces:.:;
value
of
lhese
point
of
1 e s ::;
l h all It i g- hI,)
Par t
of
industr;y
emplo.)s
Thc!'e
..
fOl'ecasling
facl
execulive
we r
S~!'VIC;:
emplu,)
sarprising;
LIlese
the
ex e cut i v e::;
shareholders.
thal
financial
f !'OW
currenc.)
a
of
services
forecasLing
booming-
to
foreig-Jl currelH:y forecasting'.
fUl'
fur :::'cas t ing-
scores
-
thi s
ill
and
lhe
purchasing
Therefore,
LhC:il
La
uf a
Forecas ling; is alsu llllpor Lallt
financing,
and markeling strategies.
lllagl1il~de
lhe direclioll and
one
is
that
are
services
;;,;u11side1'::";
lhe
u.r
,1 1' He
$100,000
of
service::;
view.
OIl
are
J.lan,Y
.s ali::; f .i e d
the exp 1 ana t i
at.
for
y,
i lh
the
top managemenl
to when explaining' poor performance
of
directors
anu
lrustees.
This
Dla.)
13
relieve
some
.J.11 S ~l C C
of
ess
blame
lh",
r :.l 1
111
put
011
The second reason 1S
providing
more
movemcnt~>:
the"
are
Given
services.
al:::,u
foreig'll
tax
in
sll'aleg'ies,
making
foreign
planning',
Lroad
curl'enc,}
of
currency
finaucial
planning
movemenls,
man,}'
services iucluuiuE,
fUlHlil~g
asse::;::;lng'
excllallge
that
currency
fOl'eig'll
prediclions
lHuvidiug
proviue integrated fina11cial
teams
that forecasting services are
fuLJrc
lhall
manag;ement
against
defending
exposure.
top
auel
international
~lmplicaliolls
exposure
uccislons,
IouI;',
services
rang;e
fillancial
awl financlllg' ueclsl0Ils.
HoI'. Foreig'u Curreuc.} Foreca::; is are Made
Fureca::;Ls
first,
-lwl
mod.els
aI'e
variables
lIlflalion
rates,
positions
anJ
type of
movements.
movemenls
predict
uses
balance
of
othel's
is
!'
called
to
lhe
anal",sLs
models.
movemenls.
al
Ccl1'rency
an
iJ.liliLiIlb
relalive
,
reserve
assel
t!sti:nate.
The
movements
Lo
fundamental
Technical
the
Econometric
forecas L.
charls
of
fUIlo.ameIltal
fOI'lll"da~
f101'.s,
lechnical
underlying;
the
The
political
"seat
d iff e r en t .i a 1 !:::
arl'IVe
use
lhe
calleo.
paymenls
historical
loday's
ale
g;rO-lps.
ecunOlll1C,
011
econoIllel;'lc
illlere~t
Technical
fuLure
sometimes
IS
forecast
with
based
different
cOlllplicaleu malhemalic(d
man,}
relale
Lhree
secuno. aPPI'oacil,
as
forecasts
-
The
approach,
laI'I;','e
into
evalualions
facLuI's,
approacL".
for'2casllllg;
third
elividcd
sclbjective
Lechulcal
pauLs
drc
Tedml cal
to
fulJre
compare
faclors
forecasts
pas t
to
pruvide
14
exchange rale movements l'alher
ACC~lrac.)
If
all
can
markets are efficient,
ageucies.
Markel
1s
iIlfol'Ulalioll
hisloriciil
movemeIlLs
be
made
then
there
reflecLeu
spol
rales.
IS
the
no
lhal
insig'hl
Thus,
foreig;u
place for
::0
cJrreuL
III
cor:.laiH
lhat
implies
efficieuc.>
reconls
or
For~casls
of C'JrreIlCS
a!'i;'umelll
than pOIIlt eslimates.
all
me lllOC. woulu nut b(; effective to eaI'Il a pI'of i l
CJl'reuc.)
marke t.
exchang'e
market
exchallg'e
rale
HOl'.-e'oer,
:;luuies
preo.l(:Lor.
g'euel'all.)
if
1S
a
have
provio.eu
corpol'alion::;
a
the
lS
predictor
the
::;110\\"1
example,
For
spot
g'ood
t l, ~,
to
efficienl
1S
furecastillg
forward
corolla!'J
A
more
sel'vices
rate,
the.)
l r.) i ng'
lo
the
of
acc..:.rale
can
I' educe
lhe
that
currenc.)
tecllll.i.~al
the foreigll
1 It
that
the
r 0 l' e 1 gIl
iuea
thal
the
fOl'warcl
the
fJ.t-lJ'2
rale
l<'1
.:..;pot
be
inuicalioH
l'
the
L.l.lulC
yalJaLl~
foreign
poor
moo.els
ocltper'form
prove
l he i
u1
rate.
a
auto-regl'es~;.iye
consislentlj
would
allo.
view
forward
best
current
fulure
definition.
b,Y
forecasting
prlces
inlo
exchal1ge
th"
to
CUl'l'enc.)
expo:;ure.
EvalJ.atioI1 of Forecasting' Accul'ac.}
The following' secliOll of
evalua ling
the
ability
lhis paper will
uf
forecasllllg
look at studies
services
Lo
15
ou.lperform
cOIlsislenll"
before,
forecasts
are
lhe
forward
based
on
econometric models or
technical
:'eplicative
ru.les,
model
evalualed ill
The
use
:JI'
SLld.)'
rules
subjective
service
anu
the
uses
a
forecasl
The
charlisl
.1
a
rale
s pot
0
llluuag'er
al1u
then
considered
analysis
to
us.ing'
determine if
U
::
r ale
all d
lo
the
the
technical
..\
fO-lith
s 1 ud.)
The
calculate
c:.lrrenc,Y
auvisor,Y
dUO.
rates
lhe
(Ft ,It)
each or.ig1n l],ate anu
A
St,ll)
anu
lhe
(St,:l)
/
3,8, or 12mo.
1 he
a c 1 -l a 1
l'
f :. t1 u r e s pot
expertise
l'
ate
the
are
:J 11
A correcl fOlecasl woulu
ale •
heuging
whe Lher
if
correcL
uecis.ion.
the Humber of correct
normal
that
The method of cdlc.dalioH I'.as
con'ecl
ue l erllli ne
have
to
COIl.S ide r eu
for I'. a I'll
flIt e
u~>e
thuL
forwar'u
for
(S.,u).
forecasl
A
Lo determine whether
50':'-6
"!Jc
lime period 1978-1982.
e
the
('~\ ,ll)
themselves
the s am e s i u e
leau
Hol
services
approach.
each
recordell
whel't
forecasls.
L 11
for
~
L:..(t,Jl)::(S~.n
for e cas leu
lacks a
will
mouels.
was
errol'
surve,Y
f:.i.lure sfJol
mOlllelll-llll
firsl
surves s
forecasts
actual
ilIodels
three services
covered forecasls made uuring
service.
anal,Ys!s,
Because it
forecast.ing'
S1X
malhemalical
011
percenLag'e
subject.ive
anal.)sis.
contains
ecorwmelric mouels
The
eilher
men 1 i oned
lhis paper.
fil'sL
ledm.i cal
As
rate.
a
probabil.ity
forecast::;
forecasting
based
Las l1.),
UfJOH
curve.
the results caa ue explained b;y
a
The
wa::;
is auoYt
ag'enc.)
1S
statislical
iuea
.is
random chance
to
01'
lG
v,lu;;lhel'
Lht;
fUl'u..:a::;lel's
caB cUllsistentl.)-
predict
.spu~
fulul'e
rates.
per'centage
O!l
forecasts
70~~
exceeueu
forecas L::;
::;how
correct
correct
values
and
must
cOIlsidering
furecas
::;ervices
-
abilil.)
can
the
.lH
cannot be
be
expecLeu
Laseu
identified from
the
absol...de
Ralios
forwaru
forecast
less
tha11
Per'cenlages
1.Po,
uf
25~o
respeclively.
32~o
This
Hol
are
belter
lhan
the forward ra l e.
lhe
Yen
study
auu
also
pleuicL sh()l' ,
Sterling
revealed
OIl
random
,
a
.
fe\';
fOl'Lca.sllng'
chaIlce,
allalJ:':;i~.
L e 'I i c L
absoLlle
The
these
i'~!:)ulls
lhan
c,
llle
shows
predictors
au
forward.
the
meall
lhe
rate
forward
and
,
lhat
of
d i v ide d
errol'.
than the fOl'\o\a1'd rale.
accurate
bel tel'
evidence
The st;]dy showed.
-
the
lllOrE:.'
for
a whole
1:::;
b.)
forecasls
and
oulstalldi;lg
soleI.)
F. i ell a r ,1
are
OIlL
Allhough
call Le found in Appendix 1.
rat,,',
error
periud.
have
g-ruup,
C:.ll'renc.y
Lhe 1378-1982
froUl tllt; 1978-1982 stud,)
thall
to
when
a
l11
1978-1982
the
fLlLu'e
the
l'ecorus
Thu::;,
tOl;!,ether' •
expe;'lise
.no
during'
of
lhaL random luck call
t z'ack
significant
::;ervice::;
showeu
fluclualiolls
18~o
that
Slalistics
the
of
all
tt~l'S
the
belter
were
disprovirq;i, experlise ill forecasting shuw
explaill
that
12
the
futul't:!
th
were
i
ZOl!
services
as
mUll
aUvlsor.}
i'ale
1101'
spot
rale
that most forecasters performed well
Lul
that
terut CUl'l'enc.}
pourl.}
all
on
lhe
Deutschmark.
forecaslers
fluctualions.
were
J11<111e
OIl
The
lo
17
TI1~
seconu
examined eight
forecasting services
over a
or
services
were
the
whi 1 e
'=ight
futul'e
how
acc,Hale
a c CUI' a c.}
r~lure
was
spot
evaluation
-
011
spol
the
Goodmall
a
rates
the
capilal
forecasletl
change
wo;.:ld.
iu
t hal
ret:"1I"ll
exchange
ill e
also
: !'
POl11 l
rates
C
011
e s lima l e
los e 1"
l 11 e
tv
rates.
speculaLiv(;
!":Lu"n
he
tIt e
L.}
eu
'.lI'
evalualetl
cam t:
lhe
above
as
were
the direclion of
forward
included
ear 11
as
were.
Spec~lal.ive
rIsk.
incremental
a lor
the
!..1iu
forecast::;
at
the
:~pec,d
than
for e cas l s
models
The services
were
eslimates
lhe
ecoHomeLllc
iuentlfleu
serVIces
point
bas e dOll
of
a::;
The
rale.
their
a c C Ul' a c.y
c01'l'ec~1.)
thal
six lllo11th Vel'iod.
an a 1 .y s 1 s •
pre u i eli v e
lhe i r
share of forecasts
the
five
l e dll1 i cal
l h l' e e r e 1 1 e dOll
e val u ate don
used,
Goodman,
StephEll
couuucleu
,
s:J.rve~
the
defined
},;
dollar
b,Y
illleresL
fol}owed
blindl,),
relative
reLUIH
lo
the
the
forv.al'J.
market premium and discounl.!2
Resu"lts
p!'e("L~lillg
revealeu
thal
the
ecoHomelric model.s
the direclion uf short
term CUl'renc;y fluctuations.
in predicting lhe
The ['esults also showed onl,Y a 50% accurac.}
direclion
accurac.}'
of
of
a
the
currency
forward
econometric Illodels
the
shorl
lerill.
Results
from
pOOl'
Overall,
1 e s sac cur ate 1h all
-
were
the
ll' ate g y
0
vel'
the
the
speculative
s am e
compared
The
at
r () l' Wa l' d
marginall,Y pl'ofilaLle Lu!
S
movement
I"ate.
study
deriving;
aLe • ~
reLUl"U
0
d.
also
58%
Lhe
noled
thal
estimates
agencies
were
In
7%
1
011
less profitaLle
per i
with
poinl
forecasling"
l'
did pooll.)
capital
aL
than a bu.)
Prelransacl.i.on
cost.
l"~.sk
al"(c
aml1101J.
returns
18
a\'e~'a&eu
the
1.12% annuall.>
ave.'ag·e
overall
lh~
econometlic
on
speculation,
fOl
gall!
periods of cOHsidel'able loss fOl' mo::;t
the risk adjJ::;ted relurn Yel''>
The
technicall,}'
based
TechnicaJ
could
Hol
be
forecasl:::.
oulpel'formed
.-..
UO
measured
d
1 0 • '* 6 ~~
auel
:1l0dels. 14
covered
;::;
will
be
thus makin&
economelric
Speculative return
technical
?oiul
est.imai'2s
Lhe
resulL::;
mentioniIlg'
\\o1'th
period
lhe
lhe
0 1
compan::
Lo
It
f
.jlelJ
Hol
monUl
::'lX
cUI'l'encie::;,
examined.
lvl'ecast::;
eCo!wJUet:·,ic
onl"
7. 2 8 %
bet \-I e e H
there
DespiLe
Juatll'aclive.
illodel::; ill every area
was
lHode~.:::..
\'.~licL
so
this
the
againsl
that
favor",
model:::..
the
the
~;~~lll.>
tecllIiica~
models •
The
indicale
interpretation of
thaL
a t e cllll i call.)
corporale
bas~d
the
resulls
treasurers
from
this
sLuu,}
wou.ld ue belLer
forecast
evalclaLin&
would
off
U::;lUg
shorl
term
It e dg' i ng s 1 r aLe g i e s •
The
based
on
this
trend
of
study
can
be
found
in
Appendixes 2 throug'h 5.
Summary
The
irreversible
corporations will
--
continue
cu.l'rency exposure.
wus t
COIl t i Hue
effectivel;:
to
reuucing
Thus,
means
thal
to face the problem of foreign
corporalions and flHancial
develop
the
globalisalioll
risks
method::,
of
of
fOl'eigll
servlces
efflcleut.l"
CUr!'~llC.)
awl
~XPVs:.ll'l:'.
19
Thus
we
~XCs
see
increasillgl,}
exposure
managelllelll
exchange
risk •
..1se
a
::;uch
In
combinalion
as
lo
foreign
suphisllcaled
, .I
lhere
and
leads
little
,~
cunLI'ul
and
order
indicalion
tha l
explained
b.)
forecasling'
serVlces
alone.
chance
are
becoming
meet
Lhe
serVlces
render;:,
uu.)ing
the::;e
:'lanag'emel;t ma,Y filld comfurl
defend
ag'ain::;t
c1'i lici::;lll
~XC
forecasler::; for pOOl'
wi III
cuupled
pUOl
the
high
sel'vices
..1S1Ilg-
III
from
more
demands
have
lO.i'eca:.:; leI'::;
The
lools
foreign
cust
fur
b.)-
of
their
unsound.
~\'a'y
the Se!'Vl'..;es as a
performance.
au;,
perfurmance
financiall.)'
::;hareholders
blallling
Regardless,
of
III f ae L ,
expeI,ti::;e ill tJl'euicliag fUl'eig-11 currenc,) movemcut".
--
~lYC::,
inter'-compall.}
contracts,
Lo
of
foreign
maua~;elllenl,
lag::;,
lools
111
lheir
l'i!:>k management
exchailge
The::;e
powel'f;"rl
cenlraliza.lion
centralized
forward
e l c.
to
exchange
strategies,
currenc,}
~u
effurt
addilioll
of
pl'icing
all
La
turlling
Lo
the
at present
lhe forward rate oulperform::; most forecasting seryices.
Despite
date,
there
future.
",ere
from
chance
lhe
1S
One
indus try
-
the
was
in
ill
ne"
record
fol'
thaL
IS
ear-I,)
1980",
its
infancj
forecaslers
dynami c::;
resJ.ll
reason
rea::;on
the
lhat
dismal
that
will
determine
and/or
of
~xc::;
the
when
forecastinglo
results
Lhe
Give1l
ga1H
be
ii
optimistic
flom
these
In
to
the
::;Lld.ie~
CUl'renc,}
lime,
beLter
C:ll'renCj
serVIces
ther e
a
1::;
g'ootI
understanding
lllovemcnls.
illlpl'OVeU UlatlieUlal ie models
Th 1 s
1
'
of
mii,)-'
,
on "Uieu
Lu
20
base
forecasls.
crealed.
help
evel'.yda.}
solve
-
b.y
hedging
example VvoJld be
of Illalul'il"
Second,
the
neVI
finaucial
Lrighle::;t
proLlellls
iu::;lrulllents al'e being
mind.::;
faced
bJ
011
'l'I'all
Street
corporations.
lhe more flexible fOl'wanl cOHll'acLs 111
aud value.
to
terms
21
NOTES
1. Robert Henl'e,y and BorIs AntI,
(1989), pp 59-C4.
2.
S.L. 5'rl.nva~;]lra, "Cld!:'3s1!':;"i.ag; ~Ul'~.ig·Il Exclla.ag:e,tt
Financial Executive, (1983), PI> 3G-JJ.
3. Srinvasl'ula p
62.
4. Villh
Quang
YL:...lliuatioHa.l
~.
"Briefing," L-1l'OUlOnc,y,
TraIl.
Foreign
Film:::.,
(Tol'on~o:
Exchange
Lexing,luH
:\1anagcmen t
Buok:::., 1980)
~
PI:>
Vinh Tran p 62.
6. Vinh Tran p 68.
7. ViIlh Tran p 72.
--
8. M.L Javaid, "Exchange Ri::;k Exposure j.lanagemenL and
Significant Exporter," MD, (Feb. 23,1985) PI> -1::I-J9.
9. Stephen Goodman, "'\'0 beLler
EUI'OUlOne~,
(Aug 1978) p
Lhan a
the
loss of a coin,
75.
10. Stephen H.Goodman,
"Foreign Exchange Rate Fureca::;tlng
T e cluLi 4 ..i. e ::;! I lUp 1 i cal i 0 Il::;
for'
B ;,1 Sill e s oS
P u 1 i L.> , ..
T 11 e
Journal of Finance, XXXIV. (1979) p 41C.
11. Richard Levie!.,
L.l.l'OmOllC,),
(Aug.
"CuI'reuc,} Forecasters Lose Their Wa,}, ,.
1983) p 142.
12. Slepheu Goodman, p 76.
13. Stephen Goodman, p 81.
14.
Stephen Goodmau,
I>
8-1:.
13. Clll'istille nekIllall, ":Viea!:)uri.ag" Forelg'11 ExcllaJlg"e Expo!::)ure: . . \
Practical Theo!'.} and its Applicaliou," Financial AuaL)sl,
(Oe t. 1983) pp 59-54.
1 G• Rieharu Levlch p 1-1:2.
17. Stephen Goodman p 82.
18. Slepliell Goodman p 82.
19. Stephen Cuodman p 83.
20. SLephea Goodman p 840
23
APPENDIX - 1
The following table shows lhe percentag"e of tolal
correcl
foreca~l~
for len forecast services during the period
1977 - 1982. 16
Technical ( 6 , 9 )
Econometric based (1,4,7,8,10)
(2,3,5)
Judgemental
-
1977-80
78-81
(11110 )
79-82
1
57.46
31.54
4C.30
2
40.32
33.29
1377-80
78-81
73-82
34.28
51. 54
44.91
33.34
34.31
31.23
(6mo)
1977-80
78-81
79-82
45.40
43.50
42.55
(1yr)
1977-80
78-81
79-82
1971-80
(1mo)
78-81
79-82
53.33
43.64
48.43
1977-80
78-81
79-82
57.04
49.60
50.71
49.35
45.41
1917-80
78-81
79-82
58.52
50.79
53.51
51.42
(6mo)
(1yr)
1977-80
78-81
79-82
56.30
40.87
41.32
(3mo)
(3UlO )
-
.)
"
61.24
56.06
49.38
'*
J
51.67
na
lla
49.07
42.47
.17.50
52.44
54.44
na
na
38.39
37.26
38.39
43.93
48.23
50.76
50.00
56.10
55.11
ua
na
56.57
35.56
29.31
26.29
33.33
32.35
29.52
33.59
40.40
48.24
48.33
48.78
46.15
na
na
55.56
6
7
45.22
40.34
43.54
8
57.64
49.77
48.84
9
50.00
48.32
44.68
10
37.78
53.14
;)2.10
61.11
53.01
48.15
53.33
52.53
50.59
71.72
59.90
61. 27
48.07
49.64
62.04
55.32
47.99
61.11
62.53
47.99
85.66
62.32
37.73
54.32
48.31
51.76
65.05
55.33
46.07
61.76
56.94
61.85
69.70
70.05
73.41
2:'.83
37.14
45.35
47.55
44.95
52.50
31.83
24
APPENDIX - 2
The fulluwing
table shuws
the percenlage uf
currecll,Y
furecasled spol rates fur several furecasting, service::; • A
cur;'ec~
fureca::;t
.i::; oue
thal currectl,} ideillifies
lhe
directiuu uf the future sput rate. The furcasters
III
data all used econometric models as
the basis fur
the
their
forecasl::;.17
Berkel.y
Predex
#4
#5
Average
Canadian $
.60
.27
.13
.37
Ila
.34
FF
.57
.33
.40
.38
.57
.46
DM
.24
.63
.41
.33
.53
.45
na
na
.30
na
.10
.20
S t e r 1 i ng,'
.10
.33
.47
.40
.48
.48
Average
.50
.43
.34
.34
. '* 2
.43
Swiss Franc
-
DRI
25
APPENDIX - 3
The following
lable shows
lhe percentage of foreca::;teu.
:,;pol rates for each service thal were closer lo lhe aclual
fulure spot rale than the forward rate was
Lo lhe aclual
fulure ::;pol rale.The resulls were for a six month period. and
OIlI,}'
foreca::;is from econometric models were used. 18
Forward
Rate
Forex
#4
#5
.53
ua
.31
na
DRI
.62
.65
FF
.37
.0,)
.43
.30
.27
.25
DM
.67
.57
.77
.60
.45
.63
Yen
.54
.50
.67
.0'
.37
lla
Swiss FraIlC
.80
Ili:i
na
ua
na
.10
Sterling;
.50
.60
.63
.60
.37
.29
Canadiau
--
Berkel,y
$
,. ...
,. ...,
... 0
""
APPENDIX - 4
The followiHg- table
capital for
~hows
the speculative return
lhree forecasting services during a six month
period. All forecasters in this
to derivl: lheir
B = bu,)
= lolal
XT
= no. of transactions
3.82
0.53
4.3'::;
-15--
0.70
(1.57)
(0.87)
8.78
3.02
11.80
-25-
7.35
1.19
8.72
-13-
8.93
2.22
11.16
-14-
12.42
(1.73)
10.69
-5-
10.95
(1. 63)
9.32
-21-
11.78
(1.52)
10.26
-12-
11.72
(1. (3)
10.09
-13-
9.52
2.07
11. 60
-3-
12.99
3.11
16.10
-22-
2.76
(10.28)
(7.52)
--1-1-
na
(1.70)
6.73
-14-
~T
6.70
5.35
12.25
-4-
2.62
2.04
5.26
-24-
9.24
9.83
19.17
-12-
6.19
6.04
12.23
-13-
T
XT
7.83
-4-
10.46
-24-
7.28
-12-
7. 90
-13-
(2.42)
S
( 2 • 6S)
T
XT
(6.08)
-5-
B
S
T
10.49
2.46
12.95
B
S
T
X"'
• 1
B
SwissFranc S
T
~\T
B
S
T
Averag-e
lnl'l
Forecasting
0.99
·LSO
5.59
-5-
B
~T
,-
T
na
na
na
na
T
Stel'lillg
S = sell
Average
2.70
5.34
8.04
~T
YE:;'
foreca.sls.l~
Waldner
2.50
S.22
8.72
-11-
B
DM
table used technical models
Shearson
4.61
5.19
9.80
-17-
Canadian $ S
•l="''''
r
011
-J-
-li-
-lO-
27
APPENDIX - 5
The following
table shows
the speculative reLurn on
capital for five forecasting ag'encies during a six month
period. The
slraleg""
for
lable also shows
the relurn on a buy and hold
lhe same periou. All
mouels a::; a basis for
B = uu,)
their
S
forecaslers
use econometric
fOJ'ecast.s.~9
= sell
T
=
tolal
Buy and
Ho=1~d~__~B~e~'1~'k~e=1~y__~D=R~I~~F~0~I'=e=x__~#~4~_____~#=5____~A~v~g
B (15.12)
2.52 (2.88)
na
(.60)
na
(1.48)
CanadianS S
6.88
5.16
na
3.32
lld
3.37
T (15.12)
4.40
1. 64
aa
0 . 28
ua
O.GS
FF
DM
Yen
Swiss F
Sterling
Averag"e
-
B
S
3.20
T
3.20
B
6.80
S
7.32
2.28
4.20
5.76
2.40
3.24 10.08 6.00
(.64) (3.16) (2.63) 13.80 (2.39)
1.40
.02
.08
2.60 2.37
5.72 10.00
6.52 16.03 10.84 9.95
(13.92) (1.96) (7.00) (4.04) (4.88)(6.03)
(1.56)
5.80 (1.60)
(.64)
(.36) 1.39
T
6.80
B
S
12.52
T
12.52
B
9.64
l1a
nd
lld
lld
nd
T
9.64
na
aa
na
na
B
0.12
S
S
T
0.12
T
2.86
7.36 15.56 12.92
4.80
(16.40) 13.(8) (8.92) (15.76)
(5.32) 3.88
6.16
(7.96)
14.04
4.56
10.48 (12.40)
12.04 (2.24)
2.75
2.10
8.40
4.G8
6.04
2.66
lld
12.34
na (12.86)
l1a
(1.13)
Hd
ua
na
na
nd
18.80
(6.12)
0.52
ua
2.16 6.20 6.35
1.12 (9.32) (.50)
1.52 (2.52) 2.91
(1.09)
.15
1.12
28
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