Group 5:

1. Onik Fathin Nurrohmah (C1B018043)

2. Fira Rozeni (C1B018022)
3. Sumaryanti (C1B018028)

Class: A (Management 2018)

Manajemen Keuangan Internasional

Chapter Review Basic 9

FORECASTING EXCHANGE RATES

Why Firms Forecast Exchange Rates

In reality, it is extremely difficult to forecast exchange rates with much accuracy.

However, MNCs can still benefit from forecasting exchange rates; doing so allows them
toderive reasonable forecasts of future cash flows, which enables them to make informed
financial decisions. The following corporate functions typically require exchange rate
forecasts.

 Hedging decision. Multinational corporations constantly face the decision of whether

to hedge future payables and receivables in foreign currencies. Whether or not a firm
hedges may be determined by its forecasts of foreign currency values. EX: Laredo
Co., based in the United States, plans to pay for clothing imported from Mexico in 90
days. If the forecasted value of the peso in 90 days is sufficiently below the 90-day
forward rate, then the MNC may decide not to hedge. Forecasting may enable the firm
to make a decision that will increase its cash flows.
 Short-term investment decision. Corporations sometimes have a substantial amount of
excess cash available for a short time period. Large deposits can be established in
several currencies. The ideal currency for deposits will (1) exhibit a high interest rate
and(2) strengthen in value over the investment period. Ex: Lafayette Co. has excess
cash and considers depositing the cash into a British bank account. If the British
pound appreciates against the dollar by the end of the deposit period when pounds
will be withdrawn and exchanged for U.S. dollars, more dollars will be received.
Thus, the firm can use forecasts of the pound’s exchange rate when determining
whether to invest the short-term cash in a British versus a U.S. account.
 Capital budgeting decision. When an MNC assesses whether to invest funds in a
foreign project, the firm takes into account that the project may periodically require
the exchange of currencies. The capital budgeting analysis can be completed only
when all estimated cash flows are measured in the MNC’s local currency. Ex:
Evansville Co. wants to determine whether to establish a subsidiary in Thailand. The
earnings tobe generated by the proposed subsidiary in Thailand would need to be
periodically converted into dol- lars to be remitted to the U.S. parent. The capital
budgeting process requires estimates of future dollar cash flows to be received by the
 U.S. parent. These dollar cash flows depend on the fore- casted exchange rate of
Thailand’s currency (the baht) against the dollar over time. Accurate forecasts of
currency values will improve the accuracy of the estimated cash flows and therefore
enhance the MNC’s decision making.
 Short-term financing decisions
 Long-term financing decisions
 Earnings assessment. An MNC’s decision about whether a foreign subsidiary should
reinvest earnings in a foreign country or instead remit those earnings back to the
parent may be influenced by exchange rate forecasts.

Forecasting Technique

The numerous methods available for forecasting exchange rates can be categorized
into four general groups:

1. Technology forecasting attempts to predict the future characteristics of useful

technological machines, procedures or techniques.
Researchers create technology forecasts based on past experience and current
technological developments. Like other forecasts, technology forecasting can be
helpful for both public and private organizations to make smart decisions. By
analyzing future opportunities and threats, the forecaster can improve decisions in
order to achieve maximum benefits. Today, most countries are experiencing huge
social and economic changes, which heavily rely on technology development. By
analyzing these changes, government and economic institutions could make plans for
future developments. However, not all of historical data can be used for technology
forecasting, forecasters also need to adopt advanced technology and quantitative
modeling from experts’ researches and conclusions.
2. Fundamental forecasting
The practice of using fundamental analysis to predict future exchange rates.
This involves looking at all quantitative and qualitative aspects that might affect
exchange rates, including macroeconomic data and political factors. Critics contend
that fundamental forecasting is limited as some of the data it includes is difficult to
quantify and it may miss some data that have an immediate effect of exchange rates..
3. Market-based forecasting
Analyzing future spot rates on the basis of a market-determined exchange rate
(such as the current spot rate or forward rate). In Investing, a tradable asset’s future
spot prices are estimated. Often used to determine future bond prices. To compare
current pricing with future pricing, one who is forecasting uses exchange rates and
interest rates. In Business projected sales based upon market behavior are assessed.
Sales can be influenced by related and unrelated factors when forecasting
4. Mixed Forecasting
A situation in which one or more analysts arrive at the same conclusion about
a company's future price movements, performance, or other metrics using several
different forecasting method . A company may decide to use more than one
forecasting method to get predictions of its performance. Companies do this to come
 up with a projection from different views or sources, increasing the reliability of the
data they're collecting. Using only one forecasting method may be misleading since
other factors can influence results. Companies avoid getting misleading predictions by
increasing the number of methods used to forecast.

The use of different forecasting methods can be done by one or more analysts. While
a company may use its past data to make predictions, forecasting methods based on that
information aren't usually as accurate in predicting the company's future because of
uncertainty and inflation. Instead, companies should use the information available in their
current stage to know how to take actionable steps like setting prices for current goods.

Forecasting service

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 firm’s exposure to exchange rate risk, may be provided
too. 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.

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.

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. 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.

 Search for Forecast Bias

If the forecast errors are consistently positive or negative over time, then there is a
bias in the forecasting procedure. The following regression model can be used to test for
forecast bias: realized = a0 + a1 ´ forecast + m

If a predictor is found to be biased, the estimated a0 and a1 values can be used to

correct the systematic error.

 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.
  Comparison of Forecasting Techniques

The different forecasting techniques can be evaluated:

 graphically - by comparing the distances from the perfect forecast line

 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.

Forecasting Under Market Efficiency

 Weak form market efficient hypothesis: The historical and current exchange rate
information cannot be used to forecast exchange rate movements because: today’s
exchange rates reflect all of the past the current exchange rate information.
 Semi Strong Form market efficient hypothesis: All public information cannot be used
to forecast exchange rate movements because: today’s exchange rates reflect all
public information.
 Strong Form market efficient hypothesis: All public and private information cannot be
used to forecast exchange rate movements because: today’s exchange rates reflect all
public and private information.

Foreign exchange markets are generally found to be at least semistrong-form efficient.

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.

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:

1. The use of recent exchange rate volatility

2. The use of a historical time series of volatilities (there may be a pattern in how the
exchange rate volatility changes over time), and
3. The derivation of the exchange rate’s implied standard deviation from the currency
option pricing model.

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.
 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.

How Exchange Rate Forecasting Affects an MNC’s Value

m 
n 
 
E CFj , t  E ER j , t  
 
Value =   j 1 
t =1  1  k  t

 

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of
period t

E (ERj,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