Chapter 8
Exchange Rate Forecasting
Resolving Controversies in Exchange Rate Forecasting
The Forecasting Approach and the Market Setting
Forecast Performance Evaluation: Accurate versus Useful Forecasts
Accessing the Economic Value of Currency Forecasts
Forecasting Methods: Some Specific Examples
Short-Run Forecasts: Trends versus Random Walk
Long-Run Forecasts: Reversion to the Mean？
Composite Forecasts: Theory and Examples
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Policy Issues and Special Forecasting Problems
“Consumers” of Exchange Rate Forecasts
“Producers” of Exchange Rate Forecasts
Special Problems in Exchange Rate Forecasting
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Introduction
1. Why exchange rate forecasting is important to international financial management?
Business and financial decisions depend on exchange rate forecasting, for
example:
(1) To evaluate foreign borrowing or investment opportunities,
convert expected foreign currency cash flows into their expected domestic
currency value
(2) Short-term hedging or cash management decisions
(3) A firm’s operating and strategic decisions, such as where to source inputs
and sell final products.
2. Pessimistic view regarding explaining and forecasting exchange rate movements
Two arguments against successful forecasting:
(1) If economists are not able to describe the fundamental determinants of
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exchange rates, clearly economic models will not be very useful for
forecasting.
(2) If markets are efficient, and prices are fully reflect all available information,
including structural economic information, then unanticipated exchange
rate movements are only the results of unanticipated events—and by
definition, these cannot be forecast.
3. Optimistic view
(1) Some structural models appeared capable of outperforming the random walk
in out-of-sample tests, and that short-run exchange rate changes were not
dissociated with economics events.
(2) Foreign exchange changes appeared clearly connected with “news” about
key fundamental economic variables.
(3) Some technical models appeared able to generate buy and sell signals in the
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spot market, which led to substantial speculative profit.
4. While forecasting economic variables may be possible, forecasting them for profit
should not.
◎ Market prices (of spot and forward exchange) should already reflect the
information in our forecasts.
◎ Exchange rate models and forecasting techniques are well known and in
public domain
◎ It is reasonable to presume that there are no unusual profits to be made by
using what is already known.
5. Some Notable Features
(1) The market setting--Three important factors in selecting a forecasting
approach:
◎ the exchange rate system
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◎ the forecasting horizon
◎ the unit of the forecast required
(2) Two measures of forecasting performance:
◎ accuracy
◎ usefulness
The author demonstrates that the “usefulness” measure is more appropriate
and meaningful for a broad class of financial decisions.
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Resolving Controversies in Exchange Rate Forecasting - The Forecasting
Approach and the Market Setting
1. A Framework for Forecasting Exchange Rates
(1) It seems unlikely that a single forecasting approach would be advisable or
lead to similar results in different settings.
(2) Figure 8.1. A Framework for Forecasting Exchange Rates
2. Exchange Rate System
(1) A pegged exchange rate regime
◎ Definition: Under a pegged exchange rate regime, an exchange rate is
allowed to vary within narrow bands.
◎ The pegged exchange regime is maintained ultimately by central bank
intervention at the upper and lower intervention points.
◎ Forecasting the direction of change (is easy)
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Losses in international reserves, excess inflation, and current account
deficits lead to depreciation
◎ Forecasting the magnitude of change (is possible)
The deviation from PPP offers one estimate of the likely exchange rate
change.
◎ Forecasting the timing of change (is difficult)
Since the decision to adjust the peg is typically a political decision.
◎ Figure 8.2. Actual and PPP Spot Rates: Mexico
(2) A floating exchange rate regime
◎ Definition: Under a floating exchange rate system, the exchange rate is
free to adjust quickly in response to changing relative macroeconomic
conditions.
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◎ Forecasting in a floating exchange rate environment is easier when the
market is efficient in processing available information, but forecasting
for profit can be more difficult for the same reason mentioned above.
(3) Various hybrid exchange rate systems
◎ For example: the European Monetary System, managed floating, or a
target zone system
◎ PPP will give a reasonable approximation of where the next central rate
realignment is headed.
◎ Figure 8.4. Actual and PPP Spot Rate—DM/Italian Lira
3. Forecast Horizon
(1) Rationale
(2) Technical models to short-run forecasts and fundamental models to
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longer-run forecasts
◎ Taylor and Allen (1992): a survey study
For very short-run (intraday to one-week): 90% of respondents rely on
technical models; while for one-year (or longer) horizon: 85% of
respondents rely on economic fundamentals
◎ a large proportion of unanticipated exchange rate changes is associated
with “news” about macroeconomic fundamentals—such as the money
supply, national income, the trade balance
◎ While deviations from PPP may be large and persistent, they have a
tendency to dampen out over time.
4. Foreign Exchange Units
A distinction between real and nominal exchange rates
(1) In the short-run
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In the short-run with price levels relatively constant, changes in the
nominal exchange rate and the real exchange rate are virtually the same.
(2) In the longer-run, for the nominal exchange rate
◎ Investors who hold nominal assets, such as Eurocurrency deposits or
foreign government bonds, need to forecast the nominal exchange rate
in order to estimate the domestic currency value of their foreign assets.
◎ As the forecast horizon lengthened, forecasting the nominal exchange
rate becomes more subject to error.
◎ The greater problem is that as time passes, a central bank may
persistently increase its nominal money supply, thus raising its nominal
price level and causing the nominal exchange rate to climb to a new
level.
(3) In the longer-run, for the real exchange rate
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◎ Over the long run the tendency for PPP to hold means that periods of
over- and undervaluation should cancel out, so that the real exchange
rate will be stationary, reverting back to its mean (equilibrium) level.
◎ Holders of real, productive assets need to know the real exchange rate
in order to value the expected cash flows generated by their real assets.
(4) In a world where nominal shocks dominate and real shocks are somewhat
evenly distributed across countries over time, we may expect that it would
be easier to forecast the real exchange rate in the long run than to forecast
the nominal exchange rate.
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Forecast Performance Evaluation: Accurate versus Useful Forecasts
1. Accurate Forecasts
(1) Minimizing forecast errors
Define the forecast error made at time t:
et = (St,j* - St+j) / St+j ,
St,j* is the j-period ahead forecast made at time t
St+j is the actual spot rate at time t+j
(2) Alternative criteria
Mean Error:
ME = (SUMiei) / n
Mean Absolute Error:
MAE = (SUMi|ei|) / n
Mean Squared Error:
MSE = (SUMiei2) / n
Root Mean Squared Error:
RMSE = MSE1/2
◎ In practice, the MAE and RMSE are more commonly used to estimate
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the average error size.
(3) Pitfalls
◎ The traditional measures could be misleading when the forecast is used
for financial hedging or speculative purposes.
◎ Figure 8.7. Illustrating a Pitfall in Forecast Error Analysis
2. Useful Forecasts
(1) Definition: Useful forecasts are those on the “right side of the market” and
lead to profitable speculative positions and correct hedging decisions.
(2) A test for forecasting expertise
◎ A 2×2 matrix
◎ A forecaster’s performance in terms of usefulness can be summarized
by the percentage of correct forecasts.
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p=r/n
p is the percentage of correct forecasts,
r is the number of correct forecasts,
n is the total number of forecasts
◎ A test for forecasting expertise (or market timing)
H0: p = 0.5 (no timing or expertise)
H1: p ＞ 0.5 (positive timing or expertise)
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Accessing the Economic Value of Currency Forecasts
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Forecasting Methods: Some Specific Examples – Short-Run Forecasts: Trends versus Random Walk
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Long-Run Forecasts: Reversion to the Mean？
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Composite Forecasts: Theory and Examples
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Policy Issues and Special Forecasting Problems – “Consumers” of Exchange Rate Forecasts
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“Producers” of Exchange Rate Forecasts
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Special Problems in Exchange Rate Forecasting
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