Exchange Rate Forecasting

Dr. S H Uzma
Assistant Professor
School of Management
NIT Rourkela
The proportion of (monthly or quarterly) exchange rate
changes that current models can explain is essentially
zero.
-Richard Meese
Why do we need exchange rate forecasting?
 Spot speculation
 Uncovered interest arbitrage
 Spot-forward speculation
 Option speculation
 Hedging
 Investment and capital budgeting
 Financing decisions
 Pricing decisions
 Strategic planning
 Macroeconomic conditions
 Central bank intervention
Speculating via the forward market
 Speculating without transaction costs
If we write a speculator’s expected spot exchange rate in n
years as Sn*($/£), if the speculator is risk neutral and we
ignore transaction costs, she or he will want to buy pounds
n years forward if1.

On the other hand, the risk-neutral speculator, ignoring

transaction costs, will want to sell pounds n years forward if
Speculating with transaction costs
 When there are transaction costs in the spot and the
forward foreign exchange market, a risk-neutral speculator
will buy pounds n years forward when

Similarly, the risk-neutral speculator will sell pounds n

years forward if
Speculating via the futures market
There are two small differences between the decision to buy or
sell futures, and the decision to buy or sell forward, namely
 Because of marking-to-market risk on futures, if speculators are
risk averse they might want a larger gap between the ask (bid)
futures price and the expected future bid (ask) spot price to
compensate for the extra risk. That is, there is risk from
unanticipated changes both in the spot exchange rate, as there is
on forwards, and in the interest rate, which adds marking-to-
market risk to futures.
 Futures contracts are rarely held to their maturity, and the
speculator may therefore be comparing today’s futures price with
an expected futures exchange rate for a date prior to the futures
contract’s maturity.
Speculating via the options market
 A speculator buys an option if the expected payoff exceeds the cost
of the option by enough to compensate for the risk of the option,
and for the opportunity cost of money paid for the option. Of
course, the value of an option varies with the underlying asset price
which can move the option into or out of the money at different
times during its maturity and by different amounts. Furthermore,
each of the different possible extents of being in or out of the
money occurs with a different probability. This means that to
calculate the expected payoff the different possible outcomes must
be weighted by the probabilities of these outcomes.
 Option writing is a risky speculative strategy unless, as usually is
the case, the speculator creates offsetting exposure via other
options, forwards, or futures, or by holding the currency against
which a call option is written.
Speculating via borrowing and lending:
swaps
 By borrowing dollars, buying pounds spot, and investing
in
pound-denominated securities, it is possible to achieve
essentially the same objective as buying pounds forward.
That is, at maturity, dollars are paid on the loan and
pounds are received from the investment.
 A risk-neutral speculator would use the swap to speculate
in favor of the pound if, where Sn*($/bid£) is the number
of dollars the speculator expects to be able to sell one
pounds for in n years time.
 That is, the speculator will borrow in the US, buy pounds
spot, and invest in pound denominated securities if he or
she thinks the pounds to be received can be sold spot in n
years for more dollars than must be repaid on the dollar
loan used to buy the pounds.
S0 = floating S1 = fixed
 Currency swaps not involvingKSexchange of principlrs
0

1 A B
KS1
KS0
2 A B
KS 2
KS 0
3 A B
KS3

KS 0
n A B
KS n
Econometric forecasting models
 These are models that are specified on the basis of
economic theory and estimated by an econometric method
 They are classified into single-equation and multi-
equation models
Single-equation models

The exchange rate (or its rate of change) depends on one

or more variables:

St  f ( X1,t , X2,t Xn,t )

St  a0  a1X1,t  a2 X2,t  an Xn,t
Examples of single-equation models

S t  a 0  a 1 ( P  P 
)t
S t  a 0  a 1 ( i  i  ) t  1
S t  a 0  a 1 F t 1
Problems of single-equation models
 The ‘black box’ problem
 Forecasting the explanatory variables
 Data frequency
 Structural changes
 Measurement errors
 Qualitative variables
Multi-equation models
 The ‘black box’ problem can be solved by specifying a
multi-equation model
Time series models
These are based entirely on the history of the exchange
rate:
Exchange rates move predominantly in cycles with
significant random variation

St  f (St 1, St 2 st n )

St  μt  γt  φt  εt
Cycles of the US dollar’s effective exchange
rate
160

140

120

100

80

60
80 80 81 82 83 8 4 8 5 85 86 8 7 88 89 9 0 90 9 1 9 2 93 94 95 95 9 6 97 98 9 9 00 00 0 1 02 03 0 4 05 05 06 07 08 09 10
-19 -19 -19 l -19 -19 r-19 -19 -19 -19 l-19 -19 r-19 -19 -19 -19 l-19 -19 r-19 -19 -19 -19 l -19 -19 r-19 -20 -20 -20 l -20 -20 r-20 -20 -20 -20 l -20 -20 r-20 -20
n v p u y a n v p u y a n v p u y a n v p u y a n v p u y a n v p u y a n
Ja No Se J Ma M Ja No Se J Ma M Ja No Se J Ma M Ja No Se J Ma M Ja No Se J Ma M Ja No Se J Ma M Ja
Problem with time series models
 If the FX market is weakly efficient, the exchange rate
must follow a random walk. Hence, it is not possible to
forecast the exchange rate based on its history
Market-based forecasting
 Using the current market spot and forward rates as
forecasters for the future spot rate
 This means that market-based forecasts are free and
readily available
 The reliability of market-based forecasts depends on the
validity of the random walk hypothesis and the unbiased
efficiency hypothesis
Spot and lagged forward exchange rates
(USD/AUD)
1.00

0.90

0.80

0.70

0.60

0.50

0.40
111 11111111111 1111111111111 11111111111 11111 111111111 11 111111111 1222 222222222222 2222222222222 22222
999 99999999999 9999999999999 99999999999 99999 999999999 99 999999999 9000 000000000000 0000000000000 00000
888 88888888888 8888888888999 99999999999 99999 999999999 99 999999999 9000 000000000000 0000000000000 00000
444 45555666677 7788889999000 01111222233 33444 455556666 77 778888999 9000 011112222333 3444455556666 77778
QQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQSpotQQQQQQQQQQQQQQQQ QQQQQ
Lagged QQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQQ
Forward
123 41234123412 3412341234123 41234123412 34123 412341234 12 341234123 4123 412341234123 4123412341234 12341
The forward rate forecasting error as a
percentage of the spot rate
20

16

12

-4

-8

-12
1111111111111111111111111111111111111111111111111111111111111111222222222222222222222222222222222
9999999999999999999999999999999999999999999999999999999999999999000000000000000000000000000000000
8888888888888888888888889999999999999999999999999999999999999999000000000000000000000000000000000
Judgmental forecasting
 Judgmental forecasting takes into account all factors
affecting exchange rates
 It is not based on a formula derived from a formal model
Composite forecasting

•Composite forecasting is based on two or more

forecasts that are derived independently
•Forecasting accuracy can be increased by pooling
different forecasts

ˆ Sˆ1  Sˆ 2
Sc 
2
Sˆ c  w 1 Sˆ1  w 2 Sˆ 2
Sˆ c  β 1 Sˆ1    β k Sˆ k
Why composite forecasting?
 Different forecasters have different degrees of forecasting
accuracy
 Diversification reduces the risk of large forecasting errors
Forecasting performance evaluation
 Performance out of sample is more meaningful
 The loss function is important
Measures of forecasting accuracy
 Mean absolute error (MAE)
 Mean square error (MSE)
 Root mean square error (RMSE)
Magnitude versus direction
 Sometimes it is more important to predict the direction
rather than the magnitude of the change
 The prediction-realisation diagram can be used to
represent magnitude and direction errors
The prediction-realisation diagram
 Actual change

 D  E  Line of perfect forecast

 H

 A

 B

 Forecast change
 C
 G

 F
Market efficiency and trading rules
 Market efficiency implies that it is not possible to make
profit by adopting a mechanical trading rule or by
following buy-sell signals extracted from charts
Filter rules
 An x% filter rule means that a currency is bought when it
appreciates by x% from the most recent trough and is sold
when it depreciates by x% from the most recent peak
A single moving average rule
A single moving average rule means that a currency is bought
when the moving average cuts the exchange rate series from
above and is sold otherwise
2.00

1.90
Exchange rate

1.80

1.70 Moving average

1.60
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Double moving average rule
 A double moving average rule says that a buy signal is
indicated when the long moving average crosses the short
moving average from above, and vice versa
Summing Up
 In the absence of transaction costs, a risk-neutral forward
speculator buys a foreign currency forward if the forward price
of the currency is below the expected future spot price. A risk-
neutral speculator sells forward if the forward price of the
foreign currency exceeds the expected future spot price.
 With transaction costs, a risk-neutral speculator buys if the
forward ask price of the foreign currency is less than the
expected future spot bid price, and sells if the forward bid price
exceeds the expected future spot ask price.
 Futures speculation is similar to forward speculation except that
the futures contract can be sold back to the exchange prior to
maturity allowing gains and losses to be taken. There is also
marking-to-market risk on currency futures.
 A speculator buys a call on a foreign currency if the probability-
weighted sum of possible payouts based on the speculator’s
opinion exceeds the price of the option by enough to compensate
for the opportunity cost and risk involved.
 Investment in favour of a foreign currency can be achieved by
borrowing domestic currency, buying the foreign currency spot,
and purchasing an investment instrument denominated in the
foreign currency. This is a swap and is equivalent to buying the
foreign currency forward.
 It is possible to speculate against a foreign currency by borrowing
that currency, converting it spot into domestic currency, and
investing in the domestic currency.
 Not hedging an exposure that can be avoided is speculation.
 Speculation offers abnormal returns if markets are inefficient. In an
efficient foreign exchange market, relevant information is reflected
in exchange rates. Weak-form efficiency occurs when relevant
information on past exchange rates is reflected in current rates;
semi-strong efficiency when all publicly available information is
reflected; and strong-form efficiency when all information, public
and private, is reflected.
 A difference between the forward rate and the expected future spot
rate is called forward bias. A joint test of forward bias and of
foreign exchange market efficiency is to regress forward rates and
other relevant information on realized spot exchange rates. The
absence of forward bias is implied by a zero constant and a
forward-rate coefficient of unity. Efficiency is implied by zero
coefficients on any other included variables.
 Efficiency can also be tested by examining the sequential
errors in forward forecasts of realized spot exchange rates.
Omitted information is likely to cause sequentially related
(persistent) prediction errors.
 Forward bias is the risk premium that forward market
participants require to compensate them for taking positions
in particular currencies. Others are willing to pay this
compensation to avoid risk.
 Exchange-rate forecasting models have not generally
predicted well outside the estimation period. This is the case
even when realized values of variables believed to influence
exchange rates are used in the formation of predictions.
 Correlations between exchange rates and variables believed to
affect exchange rates are generally low and sometimes have the
opposite signs to those we would expect.
 While widely expected events should not cause exchange rates
to change, surprise events should affect exchange rates.
Evidence on the effect of surprises is mixed.
 Slowly changing opinions among market participants about the
underlying policy regime governing exchange rates can
generate data that appears to support market efficiency, when in
fact it is caused by shifting beliefs about the relevant regime. It
is important that any model used to judge market efficiency be
based on the regime beliefs that market participants hold.
 Exchange-rate forecasting services have a generally poor
record of outdoing the forward rate when predicting future
spot exchange rates. This is what market efficiency would
imply. However, some forecasts based on chartist
techniques which project according to past exchange rates,
have allowed speculators to make profits. More emphasis
seems to have been given to chartist forecasting
techniques based on their success. This could cause
exchange-rate volatility in the form of overshooting
exchange rates.