Risk Management: Ability to Forecast

Reading

• Brearly & Myers “Principles of Corporate Finance” 6th. Edition, Chapter 27

• Blake “Financial Market Analysis” 2nd. Edition, Chapters 7, Appendix B Chapter 12

• Ormerod “Butterfly Economics”

Categories For Forecasting

• General Economic Trends

• Specific Economic Series

• Prices in Financial Markets

General Economic Trends - Examples

• Population• Age Distribution• Overall Levels of Wealth• An ability to forecast some general trends• Bill Gates People

overestimate the degree of technical change over the next year and underestimate it over the next decade. No company has dominate two phases of the computer revolution

Specific Economic Series

• Some are difficult to forecast

• Growth in GDP

• Average error on UK Treasury Forecasts 1.5%, Average Growth 2%

• For US National Bureau of Economic Research, Commercial Forecasts a Failure

The Determination of Exchange Rates

An Example of Forecasting Financial Markets

Exchange Rate Arrangements 1

Free Managed Fixed Single Float Float Rate Currency

Independent No EconomicEconomic Policy Policy Independence

No Intervention in Intervention in No need toForex Market Forex Markets Intervene for no

Market

Exchange Rate Arrangements 2

Free Managed Fixed SingleFloat Float Rate Currency

US Poland EurolandSwitzerland Brazil LithuaniaRomania Belarus Barbados

Keeping Countries at Parities

• Using Reserves

• Running the Economy

• Interest Rate Adjustments

• Strongest Economy sets Policy

Problems of Forecasting Financial Markets

Price

Time

Price

t0 t1

a

a

b

c

c

Efficiency of Financial Markets

• Information is incorporated into pricePast Price InformationPublicly Available InformationAll Information

• Transactors in Markets on Average Should not be able to obtain abnormal returns

Theories of Exchange Rate Determination/Forecasting

• Fundamental - Economic Theories

• Technical - Psychological/Graphical

Forecasting the Future

• Fundamental Analysis -Underlying Economic Factors -Long Term

• Technical Analysis- Peoples Behaviour

- Patterns are Replicated- Revealed By Charting Data- Short Term

Fundamental Analysis

Fundamental Analysis

• Flows Approach to Forecasting - Forecasts Elements in Balance of Payments

• Asset Based Forecasting - Based on Choices on Assets - An evaluation of the value of the outstanding stock of a currency

Asset Pricing Theories - Monetary Theories

Asset Based Approaches 13. P = SP* Law of One Price Absolute

Purchasing Power Parity Theory

Price of Big Mac in Dollars April 1996

USA 2.36Argentina 3.00Britain 2.71Japan 2.70Switzerland 4.80Russia 1.93Poland 1.44China 1.15

Law of One Price Criticisms

• Justified on Grounds of Trade Flows

• You can’t trade Big Macs

• Many goods not traded - Roof Tiles, Haircuts

• 90% of exchange rate transactions not trade related so price of goods not a consideration

• “Rip Off Britain”

Relative Purchasing Power Parity

1. E( St) = E(Pt+1) - E(P*t+1)

Real Exchange Rates Fairly Stable in Longer Run

In Short Run Real Rates Exhibit Less Stability

(Note from here on P is used to denote inflation not price levels)

Relationship Between Spot and Forward Markets - Interest Rate

Parity

2. (1 + i) = (1 + i*) F S

3. F - S = (i - i*) Approximately equal (i - i*) S 1 + i*

Uncovered Interest Rate Parity

4. Ft,1 = Et(St+1)

5. Ft,1 - St = E St+1 - St = i - i* St St

International Fisher Effects

6. it = Et(Pt+1) + Et(rt+1)

Real Interest Rate Parity

7. E(rt+1) = E(r*t+1)

6. E St+1 - St = E(Pt+1) - Et(P*t+1) St

Asset Pricing Models - Dornbush

• Unexpected Monetary Expansion

• Interest Rate Falls

• Covered Interest Rate Parity

• Forward Premium

• Expect Rates to Rise

• Must be Overshooting

Asset Pricing Exchange Rate Forecasting

• What is the source of differential rates of Inflation ?

• Monetary Expansion - Increases in Aggregate Demand

• Issues of Time Lags and Adjustment Processes

• Role of Government - UK 1992

Example of Econometric Specification

10. St = a0 + a1mt + a2 m*t + a3yt +a4y*t + a5(it - it*) +a6st-1

Estimate equation then forecast RHS variables for forecastprofile of Exchange Rate

Technical Analysis

Discernible Trends can be identified which depend on

Investors Attitudes

A Bag of Tools

Typical Market CyclePrice

Time

a

b c

d

Resistance and Support Levels

Price

Time

Resistance

Supporta

Head and ShouldersPrice

Time

Elliot WavesPrice

Time

1

2

3

4

5

a

b

c

Chartists Also Consider

• Trends

• Trading Volumes

• Moving Averages

Evaluation of Fundamental and Technical Analysis

Evaluation

• Fundamental Longer Term - Can one say what is the correct exchange rate ?

• Technical Short Term - One can make returns on Technical Analysis of Forex Markets

• However what is the correct tool is a problem with Technical Analysis

Exchange Rates

• Determined in Financial Markets

• Where floating may be very difficult to predict since Financial Markets Efficient

• Fundamental Theories Better in the Long Run

• Technical Theories Better in Short Run

• There may be Adjustment Issues

Concluding Remarks

• May be aware of overall trends as for example stocks

• Short term movements appear to be more intractable