Chapter

9
Forecasting Exchange Rates

South-Western/Thomson Learning © 2003

 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.

B9 - 2
 Why Firms Forecast Exchange Rates
• MNCs need exchange rate forecasts for their:
¤ hedging decisions, (forecasted rate vs. forward rate)
¤ short-term financing decisions (weaken in value over
financing period. Ex: If taka rate of dollar changes from 70 to
71 then borrowing in taka needs less dollar to repay),
¤ short-term investment decisions (strengthen in value over
investment period. Ex: If taka rate of dollar changes from 70
to 69 then investment in taka gives more dollar returns).
¤ capital budgeting decisions (rate of return or NPV in parent
country currency of the foreign project),
¤ long-term financing decisions, and
¤ earnings assessment (subsidiary earnings of MNC are
consolidated and translated into parent country currency).
B9 - 3
 Forecasting Techniques

• The numerous methods available for

forecasting exchange rates can be
categorized into four general groups:
 technical,
 fundamental,
 market-based,and
 mixed.

B9 - 4
 Methods of Forecasting

• Technical forecasting involves the use of

historical data to predict future values. It
includes statistical analysis and time
series models.
• Fundamental forecasting is based on the
fundamental relationships between
economic variables and exchange rates.

B9 - 5
 Methods of Forecasting (Contd.)

• 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.
• Mixed forecasting refers to the use of a
combination of forecasting techniques. The
actual forecast is a weighted average of the
various forecasts developed.

B9 - 6
 Example of fundamental forecasting
• Suppose the US dollar rate in Taka at present is $1=Tk.68.50. You
have to forecast the rate of the next month. It is hypothesized that the
change in dollar rate in the next month (et) in absolute value depends
on the differential inflation (Ih-If) of the previous year (Inft-1), differential
interest rate (ih-if) of the previous quarter (Int t-1), and the differential
growth rate of income (gh-gf) of the previous year (INC t-1). The
regression equation takes the following form:
et = 0.3 +.4 (Ih-If) +.3 (ih-if)+2(gh-gf)

Country Inft-1 Int t-1 INC t-1

Bangladesh 8% 4% 6%
USA 5% 3% 4%

Answer: $1=Tk.68.855
B9 - 7
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
including the past data is already reflected
in the current exchange rates.

B9 - 8
Forecasting Under Market Efficiency

• If the market is strong-form efficient, then

all the relevant public and private
information including past data is already
reflected in the current exchange rates.
• Foreign exchange markets are generally
found to be at least semi-strong-form
efficient.

B9 - 9
 Payment settlements in banking network
• SWIFT (Society for Worldwide Interbank Financial Telecommunication).
Brussels based organization established in 1973 that enables financial
institutions to send and receive information about financial transactions in a
secure, standardized and reliable environment..
• CHIPS (Clearing House for Interbank Payment System). US based
organization established in 1970 to provide the electronic conversion of the
payment system.
• CHAPS (Clearing House of Automated Payment System). UK based system
established in 1984 to facilitate payment settlements.
• Nostro Account: Our account with you. Pound denominated current account
of Sonali Bank of Dhaka maintained with Midland Bank, London
• Vostro Account: Your account with us. Taka denominated account of Midland
Bank, London maintained with Sonali Bank, Dhaka
• Loro accounts: Our account with them. Current accounts of banks with
foreign banks in terms of foreign currency held on behalf of their clients.

B9 - 10
 Documentary Credit
(Chapter 19)
• A Letter of Credit (L/C) is an instrument issued by
a bank on behalf of the importer (buyer) promising
to pay the exporter (beneficiary) upon presentation
of shipping documents in compliance with the
terms stipulated therein.
• International Chamber of Commerce defined
Uniform Customs and Practices for Documentary
Credit (UCPDC) implies following features of Letter
of Credit:
 LC is an arrangements between banks
 Responsibility of banks is confined to
documents rather than goods

B9 - 11
 Documentary Credit Procedure

 Sale Contract
Buyer Seller
(Importer) (Exporter)
 Deliver Goods
   
Application Documents Present Deliver
to open LC & Claim for Documents Letter of
Payment Credit
 Present
Documents
Importer’s Bank Exporter’s Bank
(Issuing Bank)  Payment (Advising Bank)
 LC opened

B9 - 12
 Involvement of other banks
• Negotiating Bank: Additional bank that acts on behalf
of the issuing bank to certify the authenticity of LC
• Confirming Bank: Additional bank that gives additional
confirmation of payment to the one of issuing bank on
request of advising bank. The advising bank can act as
a confirming bank as well.
• Correspondent Bank: This bank acts as an agent of LC
issuing bank and makes the payment on its behalf to
the advising bank once the documents are produced.
• Accepting Bank: In case of usance bill payment is not
made on the production of the shipping documents of
delivery, rather the issuing bank accepts the bill of
exchange that the beneficiary can discount with any
bank. In such a case, a local bank of beneficiary, called
accepting bank, may perform the role of accepting the
bill on behalf of the issuing bank.
B9 - 13
 Different Types of Letter of Credit
• Clean LC vs. Documentary LC
­ Ex. Insurance documents, Commercial invoice, Certificate of
origin, Packing List, Phytosanitory Certificate, etc.
• Revocable and Irrevocable LC
­ Since 1993, all LCs if not otherwise mentioned are
irrevocable LC.
• Confirmed and Unconfirmed LC
• Fixed and revolving LC
­ Cumulative and non-cumulative
• Transferable and Non-transferable LC
­ If the exporter and manufacturer are different people then
the payment to manufacturer may be secured by
transferable LC.
• Back-to-Back LC
• Red Clause and Green Clause LC

B9 - 14