UNIVERSITY OF ECONOMICS AND LAW

FACULTY OF FINANCE AND BANKING

Chapter 7
Forecasting Exchange Rates
I N T E R N AT I O N A L F I N A N C E

Why Firms Forecast Exchange Rates

▪ Short-term investment decisions

▪ Capital budgeting decisions

▪ Earnings assessments

▪ Long-term financing decisions

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 Why Firms Forecast Exchange Rates

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Forecasting Techniques
Four forecasting exchange rates methods:

1. Technical Forecasting

2. Fundamental Forecasting

3. Market-Based Forecasting

4. Mixed Forecasting

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 1. Technical Forecasting
Involves the use of historical exchange rate data to predict future values.

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1. Technical Forecasting
Example: Tomorrow, Kansas Co. must pay 10 million Mexican pesos for supplies
that it recently received from Mexico. Today, the peso has appreciated by 3%
against the dollar. Based on an analysis of historical time series, Kansas has
determined that whenever the peso appreciates against the dollar by more than
1%, it experiences a reversal of approximately 60% of that change on the
following day. Given this forecast, Kansas Co. decides that it will make its
payment tomorrow instead of today so that it can benefit from the expected
depreciation of the peso.
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 1. Technical Forecasting
Limitations of technical forecasting:

▪ Focuses on the near future

▪ Rarely provides point estimates or range of possible future values

▪ Technical forecasting model that worked well in one period may not work well
in another

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2. Fundamental Forecasting
Based on fundamental relationships between economic variables and exchange
rates.

▪ Use of sensitivity analysis for fundamental forecasting

▪ Use of PPP for fundamental forecasting

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 2. Fundamental Forecasting
▪ Use of sensitivity analysis for fundamental forecasting: Considers more than
one possible outcome for the factors exhibiting uncertainty.

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2. Fundamental Forecasting
▪ Use of PPP for fundamental forecasting: While the inflation differential by
itself is not sufficient to accurately forecast exchange rate movements, it
should be included in any fundamental forecasting model.

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 2. Fundamental Forecasting
Example: Based on PPP, Drake Co. believes that the Australian dollar will move
in accordance with the difference between the U.S. inflation rate and the
Australian inflation rate. Drake relies on government reports indicating that the
U.S. inflation rate will be 1% over the next year and the Australian inflation rate
will be 6%. According to PPP, the percentage change in the Australian dollar’s
exchange rate (denoted as e) should be:

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2. Fundamental Forecasting
Example: This forecast of the percentage change in the Australian dollar can be
applied to its existing spot rate to forecast the future spot rate at the end of one
year. The existing spot rate St of the Australian dollar is $0.50, so the expected
spot rate at the end of one year, E(St+1), will be approximately:

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 2. Fundamental Forecasting
Limitations of fundamental forecasting include:

▪ Unknown timing of the impact of some factors

▪ Forecasts of some factors may be difficult to obtain

▪ Some factors are not easily quantified

▪ Regression coefficients may not remain constant

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3. Market-Based Forecasting
▪ Using the spot rate

▪ Using the forward rate

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 3. Market-Based Forecasting
▪ Using the spot rate: Today’s spot rate may be used as a forecast of the spot
rate that will exist on a future date.

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3. Market-Based Forecasting
▪ Using the forward rate to forecast the future spot rate:
E(e) = p
E(e) = (F/S) – 1
E(e) = expected percentage change in the exchange rate
p = percentage by which the forward rate (F) exceeds the spot rate (S)

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 3. Market-Based Forecasting
Example:
If the one-year forward rate of the Australian dollar is $0.63 and the spot rate is
$0.60, then the percentage change in the Australian dollar over the next year can
be forecasted as:

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3. Market-Based Forecasting
Rationale for using the forward rate should serve as a reasonable forecast for
the future spot rate because otherwise speculators would trade forward contracts
(or futures contracts) to capitalize on the difference between the forward rate and
the expected future spot rate.

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 3. Market-Based Forecasting
Example
Assume that most speculators expect the spot rate of the British pound in 30 days
to be $1.45, and suppose the prevailing forward rate is $1.40. These speculators
would buy pounds 30 days forward at $1.40 and, when they are received 30 days
later, sell them at the prevailing spot rate. As speculators implement this strategy
today, the substantial demand to purchase pounds 30 days forward will cause
today’s 30-day forward rate to increase.

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3. Market-Based Forecasting
Example
Once the forward rate reaches $1.45 (the expected future spot rate in 30 days),
there is no incentive for additional speculation in the forward market. Thus, the
forward rate should move toward the market’s general expectation of the future
spot rate. In this sense, the forward rate serves as a market-based forecast because
it reflects the market’s expectation of the spot rate at the end of the forward
horizon (in this example, 30 days from now).

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 3. Market-Based Forecasting
Long-Term Forecasting with Forward Rates
Long-term exchange rate forecasts can be derived from long-term forward
rates. Like any method of forecasting exchange rates, the forward rate is
typically more accurate when forecasting exchange rates for short-term
horizons than for long-term horizons.

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3. Market-Based Forecasting
Example

Assume that the spot rate of the euro is currently $1.00 and its five-year forward
rate is $1.06. This forward rate can serve as a forecast of $1.06 for the euro in five
years, which reflects a 6% appreciation in the euro over that period.

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 3. Market-Based Forecasting
Example

The U.S. five-year interest rate is currently 5% (annualized) and the British five-
year interest rate is 8%. If IRP holds, then the five-year compounded return on
investments in each of these countries is computed as follows:

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3. Market-Based Forecasting
Therefore, the appropriate five-year forward rate premium (or discount) of the
British pound would be:

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 3. Market-Based Forecasting
Implications of the IFE for Forecasts
Since the forward rate captures the interest rate differential (and therefore the
expected inflation rate differential) between two countries, it should provide
more accurate forecasts for currencies in high-inflation countries than the spot
rate.

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3. Market-Based Forecasting
Example
Alves, Inc., is a U.S. firm that does business in Brazil. It needs to forecast the
exchange rate of the Brazilian currency (the real) for one year ahead. The
company considers using either the spot rate or the forward rate to create its
forecast. The spot rate of the Brazilian currency is $0.25. The one-year interest
rate in Brazil is 20%, versus 5% in the U.S. The one-year forward rate of the
Brazilian real is $0.22, which reflects a discount to offset the interest rate
differential (according to IRP).
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 3. Market-Based Forecasting
Alves believes that:

▪ the real’s future exchange rate will be driven by the inflation differential
between Brazil and the U.S.

▪ the real rate of interest in both Brazil and the U.S. is 3%.

These values imply that the expected inflation rate for next year is 17% in Brazil
and 2% in the U.S. The pronounced forward rate discount is based on the interest
rate differential, which in turn is related to the inflation differential.

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3. Market-Based Forecasting
In contrast, using the spot rate of the real as a forecast would imply that the
exchange rate at the end of the year will be the same as it is today.

Because the forward rate forecast (indirectly) captures the differential in expected
inflation rates, Alves considers it to be a more appropriate forecast metric than the
spot rate.

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 4. Mixed Forecasting
Use a combination of forecasting techniques.

Mixed forecast is then a weighted average of the various forecasts developed.

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Forecasting Techniques

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