Forecasting Foreign Exchange Rates Using Objective Composite Models

By Lubecke, Thomas H.; Markland, Robert E. et al. | Management International Review, April 1995 | Go to article overview

Forecasting Foreign Exchange Rates Using Objective Composite Models


Lubecke, Thomas H., Markland, Robert E., Kwok, Chuck C. Y., Donohue, Joan M., Management International Review


Key Results

No single forecasting method was according to the statistical results of this study the best under all circumstances.

Introduction

Foreign exchange rate forecasting has become increasingly important since the dissolution of the Bretton Woods system and the advent of floating exchange rates in 1973. The substantial increase in exchange rate volatility has concomitantly placed a priority on the managerial function of foreign exchange risk management.

Exchange rate forecasts are used by multinational corporations in many important areas of financial management. For example, managers use foreign exchange forecasts to convert future foreign cash flows into domestic currency units; foreign and domestic costs of capital (or returns on investment) can then be compared when making a foreign financing or investment decision. Likewise, forecasts are required for deciding whether or not a foreign currency exposure should be hedged or to what extent the exposure needs to be hedged. Monthly projections of foreign subidiaries' expenses and revenues, which are included in annual budgets, also require foreign exchange rate forecasts. Furthermore, when formulating long-range strategic plans such as a subsidiary's asset and liability structure, pricing policy, or product mix, foreign exchange rate forecasts are again needed.

Currently Used Foreign Exchange Forecasting Methods

The foreign exchange rate forecasting methods in use today by both commercial services and corporate forecasting departments are primarily econometric, judgmental, or technical methods, as summarized by Levich (1983). The forward rate, which is considered an unbiased predictor of the future spot rate by some scholars (Kohlhagen 1979 and Levich 1979), may also be used to forecast foreign exchange rates in lieu of either purchasing a commercial forecast or incurring the expense of forecasting in-house. The forward rate is the rate of exchange at which ony may contract to buy or sell a foreign currency at a designated future date. As such, forward rates can be used as forecasts of future spot exchange rates. Forward contracts may be of different maturities; the more common ones are one-month, three-month, six-month, and one-year contracts.

Econometric methods usually employ a single multiple regression equation. The independent variables are economic in nature while the dependent variable is the foreign exchange rate to be forecasted. The specification of independent variables may be prompted by various economic theories such as purchasing power parity, monetary theory, portfolio balance theory, or the asset approach (Levich 1982). Single-equation models are often an oversimplification of the real world and, for this reason, some econometric models are comprised of systems of equations.

Another foreign exchange rate forecasting method is the judgmental approach. The strength of this method is that both quantifiable variables (e.g., inflation rate and money supply) and qualitative variables (e.g., capital controls, changes in tax policy, and overselling or underselling of currencies) can be incorporated. The forecasters view these factors in the light of past experience and may canvass experts in the field before agreeing upon a forecasted exchange rate.

A technical analysis is made by tracing the recent movements of the foreign exchange rate in order to predict future exchange rates; other variables are not employed in this analysis. Buy or sell signals are produced to advise clients to hold long or short positions in currencies. For example, a company advised to hold a short position in U.S. dollars and a long position in British pounds would sell its U.S. dollars in exchange for British pounds.

The Use of Composite Forecasting

When several forecasts of the same event exist, the problem of which one to choose quickly arises. Unless one forecasting method is clearly superior to the others, it is difficult to justify a selection. …

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