10 - 1 international finance lecture 22. 10 - 2 review forecasting techniques technical, ...
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INTERNATIONAL FINANCE
Lecture 22
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Review
Forecasting Techniques
Technical,
Fundamental,
Market-based
Mixed.
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Forecasting Exchange Rates &
Measuring Exposure toExchange Rate Fluctuations
Lecture 22
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Forecast Error
• Regardless of which method is used or which service
is hired to forecast exchange rates, it is important to
recognize that forecasted exchange rates are rarely
perfect.
• The potential forecast error is larger for currencies
that are more volatile because the spot rates of
these currencies could easily wander far from any
forecasted value in the future.
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Forecasting Services
• The corporate need to forecast currency values
has prompted some consulting firms and
investment/commercial banks to offer forecasting
services.
• One way to determine the value of a forecasting
service is to compare the accuracy of its
forecasts to that of publicly available and free
forecasts.
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Evaluation of Forecast Performance
• An MNC that forecasts exchange rates should
monitor its performance over time to determine
whether its forecasting procedure is satisfactory.
• One popular measure, the absolute forecast error
as a percentage of the realized value, is defined as:
| forecasted value – realized value |
realized value
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Evaluation of Forecast Performance
• MNCs are likely to have more confidence in their forecasts as they measure their forecast error over time.
• Forecast accuracy varies among currencies. A more stable currency can usually be more accurately predicted.
• 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 value = a0 + a1 Ft – 1 +
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Forecast Bias in Different Subperiodsfor the British Pound
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Comparison of Forecasting Methods
• The different forecasting methods can be
evaluated
¤ graphically – by visually comparing the deviations
from the perfect forecast line, or
¤ statistically – by computing the forecast errors for
all periods.
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Forecasting Under Market Efficiency
• If the foreign exchange market is weak-form
efficient, then the current exchange rates
already reflect historical information. So,
technical analysis would not be useful.
• If the market is semistrong-form efficient, then
all the relevant public information is already
reflected in the current exchange rates.
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• If the market is strong-form efficient, then all
the relevant public and private information is
already reflected in the current exchange
rates.
• Foreign exchange markets are generally found
to be at least semistrong-form efficient.
Forecasting Under Market Efficiency
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• Nevertheless, MNCs may still find forecasting
worthwhile, since their goal is not to earn
speculative profits but to use exchange rate
forecasts to implement policies.
• In particular, MNCs may need to determine the
range of possible exchange rates in order to
assess the degree to which their operating
performance could be affected.
Forecasting Under Market Efficiency
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Exchange Rate Volatility
• A more volatile currency has a larger expected
forecast error.
• MNCs measure and forecast exchange rate
volatility so that they can specify a range
(confidence interval) around their point
estimate forecasts.
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Exchange Rate Volatility
• Exchange rate volatility can be forecasted using:
Recent (historical) volatility,
A historical time series of volatilities (there
may be a pattern in how the exchange rate
volatility changes over time), and
The implied standard deviation derived from
currency option prices.
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Measurement to the exposure of Exchange Rate Fluctuations
Measurement to the exposure of Exchange Rate Fluctuations
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Objectives
To discuss the relevance of an MNC’s exposure to exchange rate risk;
To explain how transaction exposure can be measured;
To explain how economic exposure can be measured; and
To explain how translation exposure can be measured.
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Purchasing Power Parity
• When a country’s inflation rate rises, The demand for its currency declines.
• Imports increase
• Both of these forces put a downward pressure on high inflation country’s currency.
• Inflation rates often vary among countries and cause international trade and exchange rates to adjust.
• Purchasing power parity quantify the exchange rates to inflation rate relationship.
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Is Exchange Rate Risk Relevant?
Purchasing Power Parity Argument Exchange rate movements will be
matched by price movements. PPP does not necessarily hold.
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• One argument for exchange rate irrelevance is that, according to purchasing power parity (PPP) theory, exchange rate movements are just a response to differentials in price changes between countries.
• Therefore, the exchange rate effect is offset by the change in prices.
Purchasing Power Parity Argument
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Example
• Franklin Co. is a U.S. exporter that denominates
its exports in Euros.
• If the euro weakens by 3 percent due to
purchasing power parity.
• It implies that European inflation is about 3
percent higher than U.S. inflation.
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Currency Diversification Argument
• Another argument is that if a U.S.-based MNC is
well diversified across numerous countries, its
value will not be affected by exchange rate
movements because of offsetting effects.
• It is naive, however, to presume that exchange
rate effects will offset each other just because an
MNC has transactions in many different
currencies.
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Stakeholder Diversification Argument
• Some critics also argue that if stakeholders (such as
creditors or stockholders) are well diversified, they
will be somewhat insulated against losses
experienced by an MNC due to exchange rate risk.
• Many MNCs are similarly affected by exchange rate
movements, however, so it is difficult to compose a
diversified portfolio of stocks that will be insulated
from exchange rate movements.
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Response from MNCs
• Many MNCs have attempted to stabilize their
earnings with hedging strategies because they
believe exchange rate risk is relevant.
Is Exchange Rate Risk Relevant?
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Procter & Gamble Co.
• The primary purpose of the Company’s foreign currency hedging program is to manage the volatility associated with foreign currency purchases of materials and other assets and liabilities created in the normal course of business.
• Corporate policy prescribes a range of allowable hedging activity.
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Dow Chemical Co.
• The Company enters into foreign exchange contracts and options to hedge various currency exposures. . . . the primary business objective of the activity is to optimize¤ the U.S. dollar value of the Company’s
assets,¤ liabilities, and future cash flows
• With respect to exchange rate fluctuations.
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Types of Exposure
• Although exchange rates cannot be forecasted
with perfect accuracy, firms can at least measure
their exposure to exchange rate fluctuations.
• Exposure to exchange rate fluctuations
comes in three forms:
¤ Transaction exposure
¤ Economic exposure
¤ Translation exposure
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Transaction Exposure
• The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.
• To measure transaction exposure: Estimate the net cash inflows or outflows in
each currency, and Measure the potential impact of the
exposure to those currencies.
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Transaction Exposure
• Transaction exposure can have a substantial impact on a firm’s value.
• It is not unusual for a currency to change by as much as 10 percent in a given year.
• If an exporter denominates its exports in a foreign currency, a 10 percent decline in that currency will reduce the dollar value of its receivables by 10 percent.
• This effect could possibly eliminate any profits from exporting.
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• MNCs can usually anticipate foreign cash flows for an upcoming short-term period with reasonable accuracy.
• After the consolidated net currency flows for the entire MNC has been determined, each net flow is converted into a point estimate (or range) of a chosen currency.
• The exposure for each currency can then be assessed using the same measure.
Estimating Net Currency Flows
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Measuring the Potential Impact
• An MNC’s exposure can be measured by considering the proportion of each currency together with the currency’s variability and the correlations among the movements of the currencies.
• For a two-currency portfolio,
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Review
• Forecasting Error
• Forecasting Services
• Forecasting Bias
• Diversification Argument
• Types of Exposure¤ Transaction ¤ Economic ¤ Translation¤ Source: Adopted from South-Western/ Thomson Learning 2006