Part III

Exchange Rate Risk Management

Information on existing
and anticipated
economic conditions of
various countries and
on historical exchange
rate movements
Information on existing
and anticipated
cash flows in
each currency
at each subsidiary
Measuring
exposure to
exchange rate
fluctuations
Forecasting
exchange
rates
Managing
exposure to
exchange rate
fluctuations
Forecasting Exchange Rates
9
Chapter
South-Western/Thomson Learning 2003
See c9.xls for spreadsheets to
accompany this chapter.
C9 - 3
Chapter Objectives
To explain how firms can benefit
from forecasting exchange rates;
To describe the common techniques used
for forecasting; and
To explain how forecasting performance
can be evaluated.
C9 - 4
MNCs need exchange rate forecasts for
their:
hedging decisions,
short-term financing decisions,
short-term investment decisions,
capital budgeting decisions,
long-term financing decisions, and
earnings assessment.
Why Firms Forecast
Exchange Rates
C9 - 5
Forecasting Techniques
The numerous methods available for
forecasting exchange rates can be
categorized into four general groups:
technical,
fundamental,
market-based,and
mixed.
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Technical forecasting involves the use of
historical data to predict future values. It
includes statistical analysis and time
series models.
Speculators may find the models useful
for predicting day-to-day movements.
However, since they typically focus on the
near future and rarely provide point/range
estimates, they are of limited use to MNCs.
Technical Forecasting
C9 - 7
Fundamental forecasting is based on the
fundamental relationships between
economic variables and exchange rates.
A forecast may arise simply from a
subjective assessment of the factors that
affect exchange rates.
A forecast may be based on quantitative
measurements (with the aid of regression
models and sensitivity analysis) too.
Fundamental Forecasting
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Known relationships like the PPP can be
used for the regression models. However,
problems may arise. In the case of PPP:
the timing of the impact of inflation on trade
behavior is not known for sure,
prices may be measured inaccurately,
trade barriers may disrupt the trade
patterns that should emerge, and
other influential factors may exist.
Fundamental Forecasting
C9 - 9
In general, fundamental forecasting is
limited by :
the uncertain timing of the impact of the
factors,
the need for forecasts for factors with
instantaneous impact,
the possibility that other relevant factors
may be omitted from the model, and
changes in the sensitivity of currency
movements to each factor over time.
Fundamental Forecasting
C9 - 10
Market-based forecasting involves
developing forecasts from market
indicators.
Usually, either the spot rate or the forward
rate is used, since speculation should
push the rates to the level that reflect the
market expectation of the future exchange
rate.

Market-Based Forecasting
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Since forward contracts have low trading
volumes and are not widely quoted, the
interest rates on risk-free instruments can
be used to determine what the forward
rates should be according to IRP for long-
term forecasting.
Market-Based Forecasting
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Mixed Forecasting
Mixed forecasting refers to the use of a
combination of forecasting techniques.
The actual forecast is a weighted average
of the various forecasts developed.
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Visit http://www.yardeni.com for reviews of
international political and economic
events and their presumed global impact.
The site also presents economic and
political analyses of major economies.
Country outlooks and exchange rate
forecasts can also be found at
http://biz.yahoo.com/ifc/.
Online Application
C9 - 14
Forecasting Services
The corporate need to forecast currency
values has prompted some consulting
firms and investment banks to offer
forecasting services.
Advice on hedging and international cash
management, and assessment of the
firms exposure to exchange rate risk, may
be provided too.

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One way to determine whether a
forecasting service is valuable is to
compare the accuracy of its forecasts with
the accuracy of publicly available and free
forecasts.
Forecasting Services
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Evaluation of Forecast Performance
An MNC that forecasts exchange rates
should monitor its performance over time
to determine whether its forecasting
procedure is satisfactory.
The MNC may also want to compare the
various forecasting methods.
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Evaluation of Forecast Performance
One measure of forecast performance is
the absolute forecast error as a
percentage of the realized value:
| forecasted value realized value |
realized value
Over time, MNCs are likely to have more
confidence in their forecasts when they
know the mean error for their past
forecasts.
C9 - 18
Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
1975 1980 1985 1990 1995 2000
A
b
s
o
l
u
t
e

F
o
r
e
c
a
s
t

E
r
r
o
r

(
$
)

C9 - 19
Evaluation of Forecast Performance
The ability to forecast currency values
may vary with the currency of concern.
In particular, the value of a less volatile
currency is likely to be forecasted more
accurately.
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Mean Absolute Forecast Error
Currency as a Percent of the Realized Value
1974-1998 1974-1984 1985-1998
British pound 4.61 % 5.06 % 4.21 %
Canadian dollar 1.73 1.70 1.75
Japanese yen 5.60 5.22 5.93
Swiss franc 5.69 5.81 5.58
Evaluation of Forecast Performance
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Forecast Bias
If the forecast errors are consistently
positive or negative over time, then there
is a bias in the forecasting procedure.
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Forecast Bias
Using the Forward Rate as a Forecast for the British Pound
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
$2.60
1975 1980 1985 1990 1995 2000
Forward Rate
Realized
Spot Rate
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Forecast Bias
The following regression model can be
used to test for forecast bias:
realized = a
0
+ a
1
forecast +
If a predictor is found to be biased, the
estimated a
0
and a
1
values can be used to
correct the systematic error.
C9 - 24
Graphic Evaluation of Forecast Performance
Perfect
forecast
line
x z
x
z
R
e
a
l
i
z
e
d

V
a
l
u
e

Predicted Value
Region of
downward bias
(underestimating)
Region of
upward bias
(overestimating)
C9 - 25
Graphic Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
R
e
a
l
i
z
e
d

S
p
o
t

R
a
t
e

$1.00
$1.50
$2.00
$2.50
$1.00 $1.50 $2.00 $2.50
Forecast (Forward Rate)
Perfect
Forecast
Line
C9 - 26
Graphic Evaluation
of Forecast Performance
If the points appear to be scattered evenly
on both sides of the perfect forecast line,
then the forecasts are said to be unbiased.
Note that a more thorough assessment
can be conducted by separating the entire
period into subperiods.
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Comparison of
Forecasting Techniques
The different forecasting techniques can
be evaluated
graphically - by comparing the distances
from the perfect forecast line, or
statistically - by computing the mean of the
absolute forecast errors, and then using a
t-test or a nonparametric test to determine
whether there is a significant difference in
the accuracy of the forecasting techniques.
C9 - 28
Forecasting Under Market Efficiency
If the foreign exchange market is weak-
form efficient, then the current exchange
rates already reflect historical information.
So, technical analysis would not be useful.
If the market is semistrong-form efficient,
then all the relevant public information is
already reflected in the current exchange
rates.
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If the market is strong-form efficient, then
all the relevant public and private
information is already reflected in the
current exchange rates.
Foreign exchange markets are generally
found to be at least semistrong-form
efficient.
Forecasting Under Market Efficiency
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Nevertheless, MNCs may still find
forecasting worthwhile, since their goal is
not to earn speculative profits but to use
exchange rate forecasts to implement
policies.
In particular, MNCs may need to determine
the range of possible exchange rates in
order to assess the degree to which their
operating performance could be affected.
Forecasting Under Market Efficiency
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Exchange Rate Volatility
MNCs also forecast exchange rate
volatility. This enables them to specify a
range (confidence interval) and develop
best-case and worst-case scenarios along
with their point estimate forecasts.
Popular methods for forecasting volatility
include:
the use of recent exchange rate volatility,
C9 - 32
Exchange Rate Volatility
the use of a historical time series of
volatilities (there may be a pattern in how
the exchange rate volatility changes over
time), and
the derivation of the exchange rates
implied standard deviation from the
currency option pricing model.
C9 - 33
Various foreign exchange resources,
including exchange rate volatility based
on historical exchange rate movements,
can be found at http://www.oanda.com and
http://pacific.commerce.ubc.ca/xr/.
Online Application
C9 - 34
Application of Exchange Rate Forecasting
to the Asian Crisis
Before the crisis, the spot rate served as a
reasonable predictor, because the central
banks were maintaining a somewhat
stable value for their respective
currencies.
But even after the crisis began, it is
unlikely that the degree of depreciation
could have been accurately predicted by
the usual models.
C9 - 35
Application of Exchange Rate Forecasting
to the Asian Crisis
The large amount of foreign investment
and the fear of a massive selloff of the
currencies played key roles in the sharp
decline of the Asian currency values.
However, these two factors cannot be
easily incorporated into a fundamental
forecasting model in a manner that will
precisely identify the timing and
magnitude of currency depreciation.
C9 - 36
Impact of Forecasted Exchange Rates
on an MNCs Value
( ) ( ) | |
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Technical Forecasting
Fundamental Forecasting
Market-based Forecasting
Mixed Forecasting
C9 - 37
Why Firms Forecast Exchange Rates
Forecasting Techniques
Technical Forecasting
Fundamental Forecasting
Market-Based Forecasting
Mixed Forecasting
Forecasting Services
Performance of Forecasting Services
Chapter Review
C9 - 38
Chapter Review
Evaluation of Forecast Performance
Forecast Accuracy Over Time
Forecast Accuracy Among Currencies
Search for Forecast Bias
Statistical Test of Forecast Bias
Graphic Evaluation of Forecast
Performance
Comparison of Forecasting Techniques
C9 - 39
Chapter Review
Forecasting Under Market Efficiency
Exchange Rate Volatility
Application of Exchange Rate Forecasting
to the Asian Crisis
How Exchange Rate Forecasting Affects
an MNCs Value