International Financial Management 3
International Financial Management 3
International Financial Management 3
Objectives
This chapter stresses the value of reliable forecasts, but suggests that reliable forecasts cant always be obtained. Because no technique has been singled out as superior, various techniques are mentioned. Whatever techniques the MNC chooses, it sho uld monitor performance ove r time. The specific objectives are to:
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Objectives
explain how firms can benefit from forecasting exchange rates; describe the common techniques used for forecasting; explain how forecasting performance can be evaluated.
Forecasting Techniques
The numerous methods available for forecasting exchange rates can be categorized into four general groups:
technical, fundamental, market-based,and mixed.
Technical Forecasting
Technical forecasting involves the use of historical data to predict future values. It includes statistical analysis and time series models. Speculators may find the models useful for predicting day-to-day movements. However, since they typically focus on the near future and rarely provide point/range estimates, they are of limited use to MNCs.
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Fundamental Forecasting
Fundamental forecasting is based on the fundamental relationships between economic variables and exchange rates. A forecast may arise simply from a subjective assessment of the factors that affect exchange rates. A forecast may be based on quantitative measurements ( with the aid of regression models and sensitivity analysis) too.
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Fundamental Forecasting
Example 1:
Assume that the corporate objective is to forecast the percentage change in the British pound with respect to U.S. dollar during the next quarter. For simplicity, assume that the firms forecast for the British pound is dependent on only two factors that affect the pounds value:
1. Inflation in the United States relative to inflation in the United Kingdom. 2. Income growth in the United States relative to income growth in the United Kingdom.
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Fundamental Forecasting
*
The first step is to determine how these variables have affected the percentage change in the pounds value based on historical data.
The regression equation can be defined as BPt =b0 + b1INFt-1 + b2INCt-1 + t Where BP is the quarterly percentage change in the British pound value
INFt-1 is the previous quarterly percentage change in the inflation differential (U.S. inflation rate minus British inflation rate) INCt-1 is the previous quarterly percentage change in the income growth differential (U.S. Income growth minus British income growth) b0 is a constant b1 measures the sensitivity of BPt to changes in INFt-1 b2 measures the sensitivity of BPt to changes in INCt-1 t represents an error term
Fundamental Forecasting
* The second step is to generate the values of regression coefficients (b0, b1, and b2) by using the historical data of BP, INF and INC. To illustrate, assume the following values:
b0 = .002 b1 = .8 b2 =1.0
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Fundamental Forecasting
*The third step: use the coefficients to forecast. (Assume the most recent quarterly percentage change in INFt-1 is 4 percent and INCt-1 is 2 percent.) The forecast for BPt is BPt =b0 + b1INFt-1 + b2INCt-1 = .002 + .8(4%) + 1(2%) = .2% + 3.2% + 2% = 5.4%
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Fundamental Forecasting
* Conclusion: given the current figures for inflation rates and income growth, the pound should appreciate by 5.4 percent during the next quarter. * Note that this example is simplified to illustrate how fundamental analysis can be implemented for forecasting. A full-blown model might include more than two factors, but the application would still be similar.
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Fundamental Forecasting
Use of sensitivity analysis for fundamental forecasting. Example 2: Phoenix Corp. develops a regression model to forecast the percentage change in the Mexican pesos value. It believes that the real interest rate differential and the inflation differential are the only two factors that affect exchange rate movements, as shown in 13 this regression model:
Fundamental Forecasting
et = a0 + a1INTt + a2INFt-1 + t
where
et = percentage change in the pesos exchange rate over period t INTt = real interest rate differential over period t INFt-1= inflation differential in the previous period a0, a1, a2 = regression coefficients t = error term
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Fundamental Forecasting
* Assume that regression analysis has provided the following estimates for the regression coefficients:
a0 = .001 a1 = -.7 a2 = .6
* To forecast the pesos percentage change over the upcoming period, INTt and INFt-1 must be estimated. Assume that INFt-1 was 1 percent. However, INTt is not known at the beginning of the period and must therefore be forecasted. Assume that Phoenix Corp. has develop the following probability distribution for INTt:
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Fundamental Forecasting
Probability Possible Outcome 20% -3% 50% -4% 30% -5% * A separate forecast of et can be developed from each possible outcome of INTt as follows: Forecast of INT Forecast of et Probability
-3% -4% -5% .1%+(-.7)(-3%)+.6(1%)=2.8% .1%+(-.7)(-4%)+.6(1%)=3.5% .1%+(-.7)(-5%)+.6(1%)=4.2% 20% 50% 30%
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Fundamental Forecasting
Use of PPP for fundamental forecasting. Known relationships like the PPP can be used for forecasting Example 3: The U.S. inflation rate is expected to be 1 percent over the next year, while the Australian inflation rate is expected to be 6 percent. According to PPP, the Australian dollars exchange rate should change as follows: ef = (1 + IU.S. ) / (1 + If) -1 = 1.01 / 1.06 1 ~ -4.7%
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Fundamental Forecasting
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 the year. If the existing spot rate of the Australian dollar is $.20, the expected spot rate at the end of one year will be : E(St+1) = St (1 + ef ) = $.20 [ 1 + (-.047)] = $.1906
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Fundamental Forecasting
Note that in reality, the inflation rates of two countries over an upcoming period are uncertain and would have to be forecasted when using PPP to forecast future exchange rate. This complicates the use of PPP to forecast future exchange rates. Even if the inflation rates were known with certainty, problems may arise for the following reasons:
the timing of the impact of inflation on trade behavior is not known for sure, prices may be measured inaccurately, trade barriers may disrupt the trade patterns that should emerge, and other influential factors may exist.
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Fundamental Forecasting
In general, fundamental forecasting is limited by :
the uncertain timing of the impact of the factors, the need for forecasts of factors with instantaneous impact, the possibility that other relevant factors may be omitted from the model, and changes in the sensitivity of currency movements to each factor over time.
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Market-Based Forecasting
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.
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Market-Based Forecasting
Long-term exchange rate forecasts can be derived from long-term forward rates. Since long-term forward contracts have low trading volumes and are not widely quoted, the interest rates on risk-free instruments can be used to determine what the forward rates should be according to IRP for long-term forecasting.
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Market-Based Forecasting
* Example: The U.S. five-year interest rate is currently 10 percent annualized, while the British five-year interest rate is 13 percent. The five-year compounded return on investments in each of these countries is computed as follows: Country Five-year Compounded Return U.S. (1.10) 5 1 = 61% 5 U.K. (1.13) 1 = 84%
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Market-Based Forecasting
Thus, the appropriate five-year forward rate premium (or discount ) of the British pound would be ) / (1 + iU.K.) 1 = 1.61 / 1.84 1 = -.125, or 12.5% The results suggests that the five-year forward rate of the pound should contain a 12.5 percent discount.
U.S. 25
p = (1+ i
Mixed Forecasting
Mixed forecasting refers to the use of a combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts developed.
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Over time, MNCs are likely to have more confidence in their forecasts when they know the mean error for their past forecasts.
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Forecast Bias
If the forecast errors are consistently positive or negative over time, then there is a bias in the forecasting procedure.
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Forecast Bias
The following regression model can be used to test for forecast bias:
realized = a0 + a1 forecast + m Where a0 = intercept
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Forecast Bias
*If the predictor is unbiased, the intercept should equal zero, and the regression coefficient should equal 1.0. *If a0 = 0 and a1 is significantly less than 1.0, this implies the predictor is systematically overestimating the spot rate, for example, if a0 = 0 and a1 = .90, the realized value is estimated to be 90 percent of the forecasted value. Vice versa. *If a predictor is found to be biased, the estimated a0 and a1 values can be used to correct the systematic 32 error.
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Region of downward bias (underestimating)
. . .
$.10 $.12 $.14 $.16 $.18 $.20 $.22 $.24 $.26 $.28 $.30
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(there may be a pattern in how the exchange rate volatility changes over time), and the derivation of the exchange rates implied standard deviation from the currency option pricing model.
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