Chapter 9

Exchange Rate Risk Management

 Content
Forecasting Exchange Rates
✓ Why firms forecast exchange rates
✓ Forecasting techniques
✓ Assessment of forecast performance/forecast errors
✓ Accounting for uncertainty surrounding forecasts
 Why Forecast Exchange Rates?

✓ Hedging decisions (future payables/receivables)

✓ Short-term investment decisions (deposit)
✓ Capital budgeting decisions
✓ Reinvest or remit earnings
✓ Long-term financing decisions (overseas bond
issuance)
Why Forecast Exchange Rates?
 Forecasting Techniques
✓ Technical Forecasting
✓ Fundamental Forecasting
✓ Market-Based Forecasting
✓ Mixed
 Technical Forecasting
✓ Involves the use of historical exchange rate data to
predict future values.
✓ Technical analysis looks for the repetition of specific
price patterns.
✓ Does not rely on a fundamental analysis of the
underlying economic determinants of ER or asset
prices, but only on extrapolations of past price trends.
✓ It typically focuses on the near future, which is not
very helpful for developing corporate policies.
 Technical Forecasting
• Limitations of technical forecasting:
– Focuses on the near future
– Technical forecasting model that worked well in one
period may not work well in another
– Market of weak-form efficiency: historical and
current exchange rate information is already
reflected in today’s exchange rate => Historical data
is not useful for forecasting.
 Fundamental Forecasting
Based on fundamental relationships between economic
variables and exchange rates, for example:
 Fundamental Forecasting
Use PPP for fundamental analysis by forecasting
inflation rate differentials
 Fundamental Forecasting
Limitations of fundamental forecasting
– Unknown timing of the impact of some factors
(lagged effects), e.g.
– Forecasts of some factors may be difficult to obtain
(instantaneous effect), e.g.
– Some factors are not easily quantified, e.g., risk of
some sudden events
– Regression coefficients may not remain constant.
E.g., coefficient of inflation on change in ER could
be different when new trade barriers exist.
 Market-Based Forecasting
✓ Use of the spot rate to forecast the future spot rate
(rationale: market forces in anticipation of future
changes)
✓ Use of the forward rate to forecast the future spot rate
of the same period. Otherwise, speculators would trade
forward contracts (or futures contracts) to capitalize on
the difference between the forward rate and the
expected future spot rate.
✓ E.g., if forward rate consistently underestimates the
future spot rate, purchase forward contracts and then
sell the currency received at the prevailing spot rate.
✓ Long-term forecast: can use interest rate differentials
between two countries
Applications of 3 methods
 Mixed Forecasting
✓ Due to shortcomings of each method, should use a
combination of forecasting techniques
✓ Mixed forecast is then a weighted average of the various
forecasts
✓ The techniques considered more reliable being assigned
higher weights.
✓ The weighting could change over time.
 Forecast Error
✓ Measurement of forecast error
- Absolute forecast error as a percentage of the realized
value
✓ Forecast error among time horizons (short vs long)
✓ Forecast error over time periods (e.g., crisis vs normal
times)
✓ Forecast errors among currencies
✓ Forecast bias
 Statistical Test of Forecast Bias

✓ a0=0, a1<1: forecasted rate > spot rate (overestimating)

✓ a0=0, a1>1: forecasted rate < spot rate (underestimating)
✓ a0=0, a1=1: forecasted rate = spot rate (no bias)
 Graphical Evaluation of Forecast Bias
If a forecast error is measured as the forecasted value
minus the realized value:
✓ Negative errors indicate underestimating, while
positive errors indicate overestimating.
✓ If the forecast errors for a particular currency
are consistently positive or negative over time,
there is a bias in the forecasting procedure.
Graphic Evaluation of Forecast
Performance
 Accounting for Forecasting
Uncertainty

To account for possible errors in forecasted values of the

factors, use:
• Sensitivity analysis for fundamental forecasting
• Interval forecasts
 Methods of Forecasting Exchange
Rate Volatility

✓ Use of recent volatility level

✓ Use of historical pattern of volatilities
✓ Implied standard deviation