Forecasting Exchange Rates Brief Re-cap Law of one price Purchasing power parity theory (exchange rate between countries’ currencies equals the ratio of their price levels) Absolute PPP and Relative PPP Long run exchange rate explained in terms of Money supply and demand (Monetary approach – increase in interest rate causes currency depreciation) Long-run international interest differentials result from different national rates of ongoing inflation, predicted by the Fisher effect Empirical support for PPP and problems associated with PPP Beyond PPP (Real exchange rates - Deviations from relative PPP) Introduction Business decisions are made based off of forecasts Forecasting exchange rates is vital for currency traders and multinational corporations that are formulating international sourcing, production, financing, and marketing strategies. We’ll look at the following three distinct forecasting techniques: Efficient market approach, Fundamental approach & Technical approach. Efficient Market Approach Financial markets are said to be efficient if the current asset prices fully reflect all the available and relevant information Information like money supplies, inflation rates, trade balances, and output growth The exchange rate will only change when the market receives new information and this is random Efficient Market Approach The future exchange rate is expected to be the same as the current exchange rate, that is, FK/$ = SK/$ Random walk hypothesis suggests that today’s exchange rate is the best predictor of tomorrow’s exchange rate Current forward exchange rate can be viewed as the market’s forecast of the future exchange rate FK/$ = E(Sk/$,t+1|It) Efficient Market Approach When interest rates are different between two countries, the forward exchange rate will be different from the current spot exchange rate. Implying future exchange rate should be expected to be different from the current spot exchange rate. Future exchange rate is forecasted using either the current spot exchange rate or the current forward exchange rate Efficient Market Approach Advantages • It’s costless to generate forecasts • It is difficult to outperform the market-based forecasts unless the forecaster has private information. Fundamental Approach Uses various models like the monetary approach to exchange rate determination which suggests exchange rate is determined by money supply, interest rate and output It is therefore represented in the following equation: SK/$ = α + β1(m-m*) + β2(r-r*) + β3(y*-y) + μ Where: S = natural log of spot exchange rate m-m* = natural log of domestic/foreign money supply r-r* = natural log of domestic/foreign interest rates or velocity of money y*-y = natural log of foreign/domestic output Μ = random error term with mean zero α, β = model parameters Fundamental Approach So to create a forecast under the fundamental approach you would need to: • Estimate the structural model using historical data to determine the numerical values for the parameters such as α and β’s • Estimate future values of the independent variables like (m − m* ), (r − r* ), and (y * − y); and • Substitute the estimated values of the independent variables from Step 2 into the estimated structural model obtained from Step 1 to generate the exchange rate forecasts. Fundamental Approach Issues with the fundamental approach to exchange rate forecasting include; • One has to forecast a set of independent variables. This is subject to errors. • The parameter values, that is, α and β’s, that are estimated using historical data may change over time because of changes in government policies and/or structure of the economy. • The model itself can be wrong. Technical Approach Analyzes past behavior of exchange rates to identify “patterns” and then projects them into the future Technical approach analysts follow trends Technical analysts may take into consideration various transaction data like trading volume, outstanding interests, and bid-ask spreads to aid their analyses An example of technical analysis is the Moving Average crossover rule You compute moving averages, in the short term (50 days) and long term (200 days) from daily exchange rates The SMA will lie below (above) the LMA when the dollar is falling against the kwacha. Point A (golden cross) says dollar may continue to appreciate Point B (death cross) signals that the dollar may depreciate for a while (signal to sell it) Exchange Rate K/$ B o SMA A o IA LMA IB Time Technical Approach Another example of technical approach is the head-and-shoulders pattern The HAS pattern consists of a head, two shoulders, left and right, and the neckline (support level). This pattern is typically viewed as signal that a currency is going to perform badly and a major reversal is coming. Left shoulder occurs as the dollar reaches a local high point & then falls back to the neckline then appreciates to the head before falling to the neckline Exchange Rate K/$ Right shoulder occurs when the dollar appreciates again but to a local high point lower than the head. Head Left Shoulder Neckline (Support) HAS is complete when the neckline is broken. When dollar depreciates through neckline signaling significant depreciation Right Shoulder Neckline (Support) Break out Time Performance of Forecasts EMA performs better than forward rate Forward rates and random walk model more accurate than fundamental models Technical approach analysts change forecast direction more often than fundamentalists Technical approach analysts perform better in the short run while fundamentalists perform better in the long run Uncertainty regarding economic policy and macroeconomic and financial conditions significantly affects professionals’ forecasts Professionals who are good at forecasting exchange rate are found to also be good at forecasting fundamentals specifically, interest rates Performance of Forecasts Forecasting is better done for developed countries currencies compared to developing countries currencies Long-term forecasts are more accurate than short-term forecasts Success in forecasting exchange rates depends on the choice of predictor, forecast horizon, sample period, model, and forecast evaluation method Traditional economic predictors such as output and money do not perform as well as predictors such as net foreign assets.
