Module 2

Session 3 :Forecasting Exchange

Rates
Session Overview

A. Why Firms Forecast Exchange Rates

B. Forecasting Techniques
Session Objectives

A. Explain how firms can benefit from

forecasting exchange rates
B. Describe the common techniques
used for forecasting
C. Explain how forecasting performance can
be evaluated
A. Why Firms Forecast Exchange Rates

“Many finance decisions are influenced by

exchange rate Projections. The derivatives
positions are taken anticipating exchange rate
movement”

 Hedging Decisions
 Short-term Financing Decisions
 Short-term Investment Decisions
 Capital Budgeting Decisions
 Earnings Assessments
 Long-term financing Decisions
B. Forecast Techniques
1. Technical Forecasting
Limitations of Technical Forecasting
2. Fundamental Forecasting
a. Use of Sensitivity Analysis for Fundamental
Forecasting
b. Use of PPP for Fundamental Forecasting
c. Limitations of Fundamental Forecasting
B. Forecast Techniques
3. Market-Based Forecasting
a. Use of the Spot Rate

b. Use of the Forward Rate

c. Rationale for Using the Forward

d. Long-Term Forecasting with the
Forward Rates
e. Implications of the IFE and IRP for
Forecast Using the Forward Rate
B. Forecast Techniques
4. Mixed Forecasting
a. Since no one method has been found
fool proof, a combination of forecasting
techniques is used
b. the techniques are assigned a weight
that totals 100 points
c. more reliable techniques assigned a
higher weight
C. Fundamental Forecasting
“Based on the fundamental relationship between
economic variables and Exchange Rates”

E = f (INF, INT, INC, GC, EXP)

“Given the current values of these variable

along with their historical impact on a currency
value, corporation can develop exchange rate
Projection”
D. Simplified Forecasting Model of
Pound and Dollar Rates

BPt = B0 + B1 INF t – 1 + B2 INT t – 1 + Ut

> A set of historical data is used to obtain previous

value of BP, INF and INT.
> Using the dataset from Regression Analysis will
generate the values of the regression Co-efficients
and their Signs (B0, B1 and B2)
> Assume B0 = .02, B1 = .8, B2 = 1.0. Construct the
forecasting model.
D. Forecasted Exchange Value of Pound

> To develop forecasted value, assume that the most

recent quaterly INF (Inflation Rate Differential) is 5% and
INT (Interest Rate Differential) is 7%
> What is the expected change in value
for the Pound?