Currency Forecasting

• Currency forecasts are used to quantify transactions exposure.
• Currency forecasts are used to value foreign projects.
• Currency forecasts develop international operational strategies.
• Currency forecasts establish prices for products and manage working capital.
• Currency forecasts evaluate the desirability of investing in foreign equity and bond markets .
• Currency forecasts can help decide whether to hedge the currency risks.
• International transactions are usually settled shortly.
• Exchange rate forecasts are necessary to evaluate the foreign-denominated cash flows involved in international transactions.
• Exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment.
• There are four pure approaches to forecasting foreign exchange rates
• The fundamental approach
• The technical approach
• The market-based approach
• The mixed approach

Fundamental forecasting

• Forecasting is long term
• Fundamental macroeconomic factors are utilized to predict future exchange rates
• Formal economic models of exchange rate determination are used
• It involves multiyear forecast
• Economic relationships and financial data are examined to arrive at a forecast
• Short-term horizons: Asset Choice Model
• Long-term horizons: Parity Models
• GNP, Consumption, Trade balance, Inflation rates, Interest rates, Unemployment, Productivity indexes

Fundamental Analysis: Short Term

• Asset Choice examines why one currency might be preferred over others.
• Variables include relative interest rates and political/country risk.
• It identifies why the demand for a currency will change.

Fundamental Analysis: Long Term

• Parity Models calculate an “equilibrium" exchange rate in the future.
• Purchasing Power Parity Model
• International Fisher Effect

Purchasing Power Parity

• It is one of the oldest exchange rate models.
• Exchange rates will change to offset relative prices levels between countries.
• Countries with relatively high rates of inflation will show currency depreciation
• Countries with relatively low rates of inflation will experience currency appreciation
• In equilibrium, the amount of depreciation (or appreciation) will be equal to the inflation differential.

International Fisher Effect

• Exchange rates will change in direct proportion to relative differences in long-term interest rates.
• Long-term interest rates capture the market's expectation for inflation.
• Countries with relatively high rates of long-term interest rates will show currency depreciation.
• Countries with relatively low rates of long-term interest rates will show currency appreciation.
• In equilibrium, the amount of depreciation (or appreciation) will be equal to the long-term interest rate differential.

Technical Forecasting

• Forecasting is short-term
• Uses only past exchange rate data and other financial data to predict future exchange rates
• Future exchange rate information is present in past trading behavior.
• Technical analysis looks for the repetition of specific price patterns.
• Charts and price patterns are used to forecast future moves in spot exchange rates.
• Looks for price patterns that have historically signed a future move.
• It assumes that a historical relationship will result in similar moves in the future.

Technical Forecasting Methods

• Chartism
• Filter rules
• X % rules
• Common x % rules - 1%,2%
• Moving average Cross-rule

Chartism

• Chartists graphically record the actual trading history of an exchange rate and then try to infer possible future trends
• Peaks and troughs in the price series are needed to identify trends through the use of charts.
• A peak is the highest value of the exchange rate within a specified period
• A trough is the lowest value the price has taken on within the same period
• A series of peaks and troughs establishes downtrends and uptrends, respectively.
• Support level means the price has trouble falling below a particular level
• Resistance level means the price has trouble rising above a particular level.
• The support level and Resistance level define the trading range.
• Breakout happens when a trading range is broken and a sudden rise or fall in prices expected.
• Chartists identify spurious patterns.
• Chartists don't believe in efficient financial markets.

FILTER RULES

• It is a popular method for detecting trends in exchange rates and a trading strategy based on the history of an asset price.
• It provides signals to an investor to buy or sell a currency.

X % Rules

• Go long in foreign currency after the foreign currency has appreciated relative to $ by x % above its support level.
• Go short whenever currency falls x % below the resistance level.

Moving average crossover rules

• Moving averages of the exchange rate are used.
• n-day moving average - sample average of the last n trading days including the current rate.
• A (y,z) moving average crossover rule - uses averages over a short period (y days) and a long period (z days).
• Go long in the foreign currency when the STMA crosses the LTMA from below.
• Common rules - (1,5),(1,20),(5,20).

Why technical analysis might work

• It is extensively used by forex dealers.
• There are inherent problems in fundamental analysis
• Picking the right exchange rate model
• Forecasting the model's fundamental variables
• Non-availability of all macroeconomic inputs at frequent intervals
• Poor measurements
• Forward rate is not an unbiased predictor of future spot rate even in an efficient market.
• The sufficiently large amount of trading world is using technical analysis
• Demands and supplies will be buffeted by these irrational traders.

Market based Forecasting

• It develops forecasts from market indicators.
• Either the spot rate or the forward rate is used.
• Speculation should push the rates to the level that reflects the market expectation of the future exchange rate.
• Nominal interest rates are used when no forward markets exist for a particular currency.

Mixed Forecasting

• Combination of forecasting techniques are used.
• The actual forecast is a weighted average of the various forecasts developed.

Evaluating Forecasts

• There are 3 dimensions to evaluate the quality of forecasts
• Accuracy
• Forecast error = actual exchange rate - forecasted rate
• Two measures of accuracy include Mean absolute error and Root mean squared error
• Percentage Correct evaluation of a forecasting record
• Involves finding the % of times the forecaster was on the correct side of the forward rate.
• Should be strictly larger than 50 % for the forecaster's services to add value to the decision-making process.
• Profitability of Technical forecaster's
• Technical forecaster's performance is characterized by a relatively small number of successful forecasts in which large profits are made and a relatively large number of incorrect predictions in which small losses are incurred.
• Compute profits or losses made based on the forecaster's advice and compare those returns to returns on alternative investments that do not require forecasts.

The applications and methods of currency forecasting. It covers technical analysis, fundamental analysis, and parity models. It uses economic indicators to predict exchange rates and manage financial risks.