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Chapter 9
Forecasting Exchange Rates
Lecture Outline
Why Firms Forecast Exchange Rates
Forecasting Techniques
Technical Forecasting
Fundamental Forecasting
Market-Based Forecasting
Mixed Forecasting
Guidelines for Implementing a Forecast
Forecast Error
Measurement of Forecast Error
Forecast Accuracy Among Currencies
Forecast Error over Time Periods
Forecast Bias
Graphic Evaluation of Forecast Performance
Comparison of Forecasting Methods
Forecasting Under Market Efficiency
Using Interval Forecasts
Methods of Forecasting Exchange Rate VolatilityChapter Theme
This chapter stresses the value of reliable forecasts, but suggests that reliable forecasts can’t always be
obtained. Because no single forecast technique has been singled out as superior, various techniques are
mentioned. Whatever techniques the MNC chooses, it should monitor performance over time. This
chapter illustrates how this evaluation can be accomplished.
Topics to Stimulate Class Discussion
1. Which forecast technique would you use if you were hired by an MNC to forecast exchange rates?
2. Do you think there will ever be a published technical forecasting model that you could use in the
future to most accurately forecast exchange rates? Why or why not?
3. Recall the theories of purchasing power parity (PPP) and international Fisher effect (IFE) in Chapter
8. If these theories were used to forecast exchange rates, which techniques would they be classified
as? Why?
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Forecasting Exchange Rates 2
4. Assume there is a regression model that was able to identify the factors which affected exchange rate
movements in a recent four-year period. Also, suppose that the sensitivity of the exchange rate’s
movements to each factor was precisely quantified. Is there any reason not to expect superior
forecasting results from this method in the future? Elaborate.
5. What is the use of detecting a forecast bias?
POINT/COUNTER-POINT:
Which Exchange Rate Forecast Technique Should MNCs Use?
POINT: Use the spot rate to forecast. When a U.S.-based MNC firm conducts financial budgeting, it
must estimate the values of its foreign currency cash flows that will be received by the parent. Since it is
well documented that firms can not accurately forecast future values, MNCs should use the spot rate for
budgeting. Changes in economic conditions are difficult to predict, and the spot rate reflects the best
guess of the future spot rate if there are no changes in economic conditions.
COUNTER-POINT: Use the forward rate to forecast. The spot rates of some currencies do not represent
accurate or even unbiased estimates of the future spot rates. Many currencies of developing countries
have generally declined over time. These currencies tend to be in countries that have high inflation rates.
If the spot rate had been used for budgeting, the dollar cash flows resulting from cash inflows in these
currencies would have been highly overestimated. The expected inflation in a country can be accounted
for by using the nominal interest rate. A high nominal interest rate implies a high level of expected
inflation. Based on interest rate parity, these currencies will have pronounced discounts. Thus, the
forward rate captures the expected inflation differential between countries because it is influenced by the
nominal interest rate differential. Since it captures the inflation differential, it should provide a more
accurate forecast of currencies, especially those currencies in high-inflation countries.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: To the extent that high expected inflation leads to weakness of a currency, the forward rate
should provide a more appropriate forecast. However, for some very short horizons, the inflation
expectations may not have much influence.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
