TOPIC: FOREIGN EXCHANGE RATE FORECASTING
Introduction
Exchange rate forecasting can be described as a formal and a proactive process of generating
expectations about value of domestic currency relative to other currencies.
Decisions regarding international business transactions and activities require consideration of multiple
currencies and the impact of changes of their values on such activities, business events and transactions.
In order to be able to make precise decision on whether and when to mitigate the impact of exchange
rate volatility on their undertakings, the multinational corporations, international firms and business men
operating in a global context are inevitably in need for exchange rate forecasting. This becomes even
more critical under the floating exchange rate regime where exchange rate is dependent on market
forces. It follows that the global firms, traders, arbitrageurs, speculators and public in general need to
proactively forecast state of exchange rate and incorporate the output of such forecasting in their
decision-making equations. These decisions could be as informal as travelling overseas to as formal as
capital budgeting, global financing, and speculation decisions by business firms and traders. Exchange
rate forecasting is thus critical as it enables managers to avoid making currency risk unconscious
decisions. Although forecasting could not be taken as accurate as to the level of eliminating the currency
risk, it can play a great deal in minimizing that risk.
The need for exchange rate forecasting
It is stated earlier in this study guide chapter that the exchange rates a significant part of long-term
decisions likely to be interrupted by change in value of currencies denominating transactions and
activities of such decisions. The exchange rate forecasting is therefore a pre-requisite in implementing
different decisions especially, those which involve the use of multiple currencies. The exchange
forecasting is needed for various reasons. The reasons and motives for exchange rate forecasting are as
discussed below:
1. Speculating purposes
Speculation involves making decisions to buy, sell or hold a certain amount of a currency/derivative
instrument in anticipation of making profit out of exchange rate fluctuations. Speculators therefore buy
currency or derivatives today if it is expected that the currency/derivative will appreciate in value so that
to sell it in future and vice -versa. The speculators make decisions regarding their activities in spot
market, forward market, option and futures markets with the help of exchange rate forecasting.
2. Hedging purposes
The global firms or individuals engage in hedging activities in order to minimise or eliminate altogether
the risk arising from exchange rate volatility. Since hedging is not by itself a cost free activity, the firm
or individual will only hedge when necessary and when the benefits of hedging exceed involved costs.
The decision whether to hedge a transaction (payable or receivable) involving foreign currency but due
in future date or otherwise will depend on whether the spot rate prevailing at the date of settlement is
favourable or not. To know the expected spot rate at the date of settlement require forecasting. Hedging
decision is therefore influenced by the results from exchange rate forecasting.
3. Pricing decisions
The forecasting of exchange rate is important for international business firms and multinational
corporations in setting prices of products that are necessarily produced in one country, from imported
raw material, and consequently sold in difference foreign countries. Pricing decision for a product
requires the understanding of whether the currency denominating its sale or purchase of raw materials is
strong or weak relative to the domestic currency. We need the forecasting of exchange rate to achieve
that.
4. Financing decisions
In addition to information regarding interest rates business firms will prefer its debts (financing source)
to be denominated in a currency expected to depreciate over the loan period. This will make the
company use fewer domestic currencies in the repayment of principal and interest amount (cheaper).
This calls for exchange rate forecasting.
5. Investment and capital budgeting decisions
More importantly the exchange rate forecasting is required in making long-term foreign investment
decisions. The international business firms will need to invest in a currency expected to appreciate over
the investment period such that the fewer foreign currencies will yield substantial amount in domestic
currency. In addition to that the international capital budgeting process requires estimation of cash flows
expressed in a currency of investment. This equally calls for the forecasting of the expected spot
exchange rates through which the estimated foreign cash flows will be converted into domestic currency.
The equilibrium theories such as the International Fisher Effect (IFE) and Purchasing Power Parity
(PPP) are commonly used for this purpose.
6. Strategic planning
The multinational firms require exchange rate forecasting for strategic planning such as the choice of the
production location, foreign markets and source of materials. These multinational firms will normally
need to incur costs in countries where currencies are expected to depreciate and earn revenue in
countries where currencies are expected to appreciate. The exchange rate forecasting is therefore crucial
to facilitate the strategic decision making process by global firms and international business enterprises.
7. Arbitrage decisions
Amongst the participants in the foreign exchange market is arbitrageurs. The arbitrageurs engage in
arbitrage activities by buying currencies from where they are considered cheaper and resell them where
they are expensive. The arbitrage opportunities could be exploited where two markets are involved,
literary called bilateral arbitrage, or triangular arbitrage in which the prices of three currencies are
involved, referred as triangular arbitrage.
8. Central bank intervention
The Central Bank of any country plays an important role in exchange control and in ensuring the
stability of her country’s currency. Under the floating exchange system particularly central banks
infrequently interferes foreign exchange markets in order to regulate exchange rates especially where
excessive unfavourable volatility of domestic currency is anticipated. In order to know whether and
when to intervene the central banks require exchange rate forecasting. This is why there is no a purely
flexible exchange rate system but rather the dirty float system where market forces are allowed to
determine the exchange with regular interferences in the foreign exchange markets.
Approaches for forecasting exchange rates
There are four methods used to forecast exchange rates:
a.
b.
c.
d.
i.
Fundamental analysis
Technical analysis
Market-based forecasts
Mixed approach
Fundamental analysis is a currency forecasting technique that uses fundamental relationship
between economic variables such as( inflation rates, national income growth, changes in money
supply and other macroeconomic variables ) and exchange rates.
This includes:
Purchasing Power Parity (relative version)
Example
The spot rate is $0.73 per Australian dollar. The USA will have an inflation rate of 3 percent per year for
next 2 years, while Australia will have an inflation of 5 percent per year over the same period. What
will be the US dollar price of the Australia dollar be in 2 years?
Problems or Limitations of using PPP in exchange rate forecasting
1. It is based on the efficient market hypothesis ie It works under efficient market, in reality the
markets are not efficient, there are lot of imperfections
2. The theory ignores the impact of other variables by considering only inflation rate
3. It is difficult to forecast inflation rate especially over long period of time, this is because inflation
rate is itself determined by number of factors and therefore is difficult to have accurate forecast.
Multiple Regression Analysis
This is used when exchange rates depend on number of macroeconomic variables.
The percentage change will be determined by establishing the regression of differential of given
macroeconomic variables among given countries.
Example
Assume that the spot rate between British pound and US dolla is $ 1.28/£ and the constant regression
coefficient is 0.001, regression coefficient for inflation rate differential is 0.5, for money supply growth is
0.8 and that of national income is 1 where as respective differentials are 2%, 3% and 4%. Find the
percentage change in British pound
Activities involved in Fundamental forecasting of exchange rates
Fundamental forecasting is based on fundamental relationship between economic variables and exchange
rates. Given current values of these variables along with their historical impact on a currency’s value,
dealers or other participants in FOREX markets can develop exchange rate projections using some
models.
The main activities are:
•
•
To select Exchange Rate Forecasting Model
To identify the fundamental factors that determine exchange rates;
•
•
To predict the future values of these factors to be used in forecasting the exchanges rates.
To forecast exchange rate using the selected model.
Limitations of fundamental forecasting are as follows:
•
•
•
•
ii.
Forecasts needed for factors with instantaneous impact might be difficult to obtain;
Uncertain timing of impact of these factors on future exchange rates;
Omission of other relevant factors from model used in forecasting.
Change in sensitivity of currency movements to each factor overtime
Technical analysis is a currency forecasting technique that uses historical prices or trends. This
focuses exclusively on past prices and volume movements rather than economic and political
factors.
The price will be forecastable only if price patterns repeat themselves.
iii.
Market-based forecasts is a forecast based on market indicators such as forward rates. The
currency forecast by extracting predictions already embodied in spot, forward and interest rates
•
Using forward rate:
The expectation theory assumes that the current forward rate is a consensus forecast of the spot rate in the
future. For example, today's 30 day forward rate is a market forecast of the spot rate that will exist in 30
days.
Example
The spot rate is $0.8000 per Canadian dollar. The 90-day forward discount for Canadian dollar is 5%.
What is the expected spot rate in 90 days?
•
Using Interest rate (IFE)
Interest differentials can be used to predict exchange rate beyond 1 year as the forward rate fails.
Problems or limitations of using interest rate differential (IFE) in exchange rate forecasting
1. The forecasting model works under efficient market conditions, however the market may not be
assumed to be efficient, so the exchange rate calculated may not be accurate as expected.
2. To forecast the exchange rate, interest rates in two countries have to be predicted, this is however
a difficult task, as there are many factors determining the level of interest rate , thus interest rate
forecast may not be accurate, which means the forecast exchange rate may not as well be accurate.
3. The forecast model assumes that interest rates are the only determinant of exchange rate, thus it
ignores the impact of other factors on the behaviour of exchange rate.
Example
The spot rate is $2 per pound. The annual interest rates are 10 percent for the USA and 20 percent for
the UK. If the interest rate remains constant, then what is the market forecast of spot rate for pound
in 3 years?
The valuation of performance of forecasters
Because exchange rate forecasts are not free, MNCs must monitor their forecast performance to
determine whether the forecasting procedure is satisfactory. Forecast performance can be evaluated
by measuring the forecast error by using either of the following:
1. Mean Absolute Error (MAE)
2. Mean Square Error (MSE)
3. Root Mean Square Error (RMSE)
The three methods should lead to the same conclusion, they are not contradictory
The small the value, the more accurate the forecaster is said to be.
Example
The forecasted value for the Canadian dollar is $ 0.7300 and its realized value is $0.7500. The
forecasted value for the Mexican peso is $ 0.1100 and realized value is $0.1000. What is the difference
between the forecasted value and the realized for both the Canadian dollar and the Mexican peso?
What is the forecast error for each of the two currencies?
REVIEW QUESTIONS
QUESTION ONE
Latang’amwaki is a well-known and successful currency speculator who relies on forecasting exchange
rates. Latang’amwaki has just seen the current spot exchange rate is TSHS.1550/$ and the six-month
forward rate is TSHS.1500/$. Based on his analysis and forecast of the exchange rate, he is pretty confident
that the spot exchange rate will be TSHS.1520/$ in six-months. Assume that he would like to buy or sell
$10,000,000.
REQUIRED:
•
•
What actions should Latang’amwaki take to speculate in the forward market?
What is the expected TSHS profit from speculation if his forecast turns out to be accurate?
(b) Briefly explain the main activities involved in fundamental forecasting of exchange rates.
(c) What are the major limitations of fundamental forecasting?
QUESTION TWO
Discuss any four reasons as to why Multinational Corporation may need exchange rate forecasting.
QUESTION THREE
You are working as financial analyst with a subsidiary of an Australian Company in Tanzania. Your
Managing Director has received forecasts of Euro exchange rates in two year's time from two leading
exchange rate forecasters in Tanzania as detailed below:
TZS/Euro forecasts
Forecaster I
Forecaster II
Year 2023
TZS 1,345/€
TZS 1,710/€
Year 2024
TZS 1,456/€
TZS 1,560/€
Year 2025
TZS 1,560/€
TZS 1,340/€
The current spot mid-rate is TZS 1667/€
REQUIRED:
Suppose the actual exchange rate turned to be TZS 1,660/€, TZS 1,670/€ and TZS 1,680 for year 2023,
year 2024, and year 2025 respectively. Calculate the mean absolute error committed by each forecaster and
evaluate the performance of the two forecasters
QUESTION FOUR
You are hired as a Financial Consultant to assess the firm’s ability to forecast. The firm has
developed a point forecast for two different currencies. It wants to determine which currency was
forecasted with greater accuracy. The following information was provided:
Period
1
2
3
4
Yuan forecast
US$ 0.050
US$ 0.048
US$ 0.053
US$ 0.050
Actual Yuan Value
US$ 0.051
US$ 0.052
US$ 0.052
US$ 0.056
Euro Forecast
US$ 15.0
US$ 15.3
US$ 15.5
US$ 14.9
Actual € Value
US$ 15.1
US$ 15.0
US$ 15.8
US$ 15.2
Required:
Which currency was forecasted with greater accuracy?
Question FIVE
It is the end of December 2022. The current A$/US$ exchange rate is 1.3526, the Australian and
US three month interest rates are 6% and 4.5% p.a respectively. A forecast indicates that the
exchange rate at the end of 2022 will be 1.2850.
Required:
(a)
(b)
(c)
(d)
What would you do on the basis of this information?
If the actual exchange rate turns out to be 1.3650. Calculate the percentage
forecasting error.
Is there an error of direction in this forecast?
How much loss will be incurred by acting on this forecast?
Question SIX
A forecaster provided the following forecasts for interest rates in Tanzania and UK.
YEAR
TANZANIA
U.K
2023
25.6
11.4
2024
25.1
8.5
2025
28.4
5.4
2026
38.3
6.8
2027
39.0
6.7
Required:
If the exchange rate at the end of 2022 is TZS 2,300 forecast the TZS value of the pound for the
years 2023 – 2027
Question SEVEN
You are financial analyst working with a subsidiary of British Company in Tanzania. Your
managing director has received forecasts of Pound Sterling exchange rates in two year’s time from
three leading banks in Tanzania.
TZS/₤ Two Year Forecasts
National Bank of Commerce (NBC)
1,452
Co-operative and Rural Development Bank (CRDB)
1,514
National Micro-Finance Bank (NMB)
1,782
The current spot mid-rate is
TZS 1,667/₤
A non-executive director of your company has suggested that in order to forecast future exchange
rates, the interest rate differential between countries should be used. She stated that “ as shortterm interest are currently 6% in the UK, and 3.5% in Tanzania, the exchange rate in two years
time will be TZS 1,748.50/₤”.
Required:
(i)
(ii)
(iii)
You are financial consultant. Prepare a brief report discussing the likely
validity of the non-executive director’s estimate.
Explain briefly whether or not forecasts of future exchange rates using
current interest rate differential are likely to be accurate.
Based on your answer to (i) above calculate the percentage forecasting error
should the actual exchange rate in two years turn to be TZS 1,700/₤