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Quantify transactions exposure
Value foreign projects, to develop international operational
strategies, establish prices for products ,manage working
capital.
Evaluate desirability of investing in foreign equity and bondmarkets.
To help decide whether to hedge the currency risks
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International transactions are usually settled in the near future.
Exchange rate forecasts are necessary to evaluate the foreigndenominated cash flows involved in international transactions.
Exchange rate forecasting is very important to evaluate the benefits
and risks attached to the international business environment.
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Four pure approaches to forecasting foreign exchangerates:
(1) The fundamental approach.
(2) The technical approach.
(3) The market based approach.
(4) The mixed approach.
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Long term forecasting Uses fundamental macroeconomic factors to predict
future exchange rates Based on formal economic models of exchange rate
determination Concerned with multiyear forecast Examines economic relationships and financial data to
arrive at a forecast. Short term horizons : Asset Choice Model
Long term horizons : Parity Models GNP, Consumption, Trade balance, Inflation rates,
Interest rates, Unemployment , Productivity indexes
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Asset Choice:
Examines why one currency might be preferred over others.
Variables include:
Relative interest rates (current and anticipated)
Political/country risk
Essentially, trying to identify why the demand for a currency will
change
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Parity Models
Through these models one attempts to calculate anequilibrium exchange rate in the future.
Analysis built on long standing economic theories ofexchange rate determination.
1.Purchasing Power Parity Model
2.International Fisher Effect
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One of the oldest exchange rate models.
Assumes that exchange rates will change to offset relative
prices levels between countries.
Countries with relatively high rates of inflation will show
currency depreciation Countries with relatively low rates of inflation will
experience currency appreciation
In equilibrium, the amount of depreciation (or appreciation)
will be equal to the inflation differential.
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Assume:
Spot GBP/USD: $1.80
Forecasted UK rate of inflation (annualized) for the next 12 months:
2.5%
Forecasted US rate of inflation (annualized) for the next 12 months:1.0%
PPP Spot GBP/USD Forecast
1 year change in GBP: $1.80 x .015 = 0.027.
1 year spot GBP: $1.80 - .027 = $1.773
6 month GBP: $1.80(0.027/2) = $1.800.0135 = $1.7865
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Assume that exchange rates will change in direct proportion torelative differences in long term interest rates.
Assumes that long term interest rates capture the markets
expectation for inflation.
Countries with relatively high rates of long term interest rates (i.e.,high inflation) will show currency depreciation.
Countries with relatively low rates of long term interest rates (i.e.,
low inflation) will show currency appreciation.
In equilibrium, the amount of depreciation (or appreciation) will be
equal to the long term interest rate differential
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Assume:
Spot USD/JPY = 98.00
Current 1 year Japanese Government Bond rate = 0.5%
Current 1 year U.S. Government Bond rate = 4.5%
Spot USD/JPY Forecast
1 year change in JPY = 98.00 x 0.04 = 3.92
1 year spot JPY = 98.00 - 3.92 = 94.08
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Short term forecasting. Uses only past exchange rate data and other financial data to
predict future exchange rates . Future exchange rate information is present in past trading
behavior
Technical analysis looks for the repetition of specific pricepatterns.
Uses charts and price patterns to forecast future moves in spotexchange rates.Looks for price patterns that have historically signed a future
move.Assume historical relationship will result in similar moves in
the future.
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Chartism
Filter rules
i. X % rules
ii. Moving average Cross over rule
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Chartists - Original Technical analysts
Chartists - graphically record actual trading history of an
exchange rate & then try to infer possible future trends
To identify trends through the use of charts, practitioners must
first findpeaks and troughs in the price series.A peak is the highest value of the exchange rate within a
specified period of time (a local maximum)
A trough is the lowest value the price has taken on within the
same period (a local minimum). A series of peaks and troughs establishes downtrends and up
trends, respectively.
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Support level - any chart formation in which price hastrouble falling below a particular level.
Resistance level - any chart formation in which price
has trouble rising above a particular level.
Support level & Resistance level define trading range.
Breakout - When a trading range is broken, a sudden
rise or fall in prices is expected.
Chartists identifies spurious patterns Chartists dont believe in efficient financial markets.
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Popular method for detecting trends in exchangerates.
It is a trading strategy based on the past history of anasset price.
It provides signals to an investor to buy or sell a
currency.
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Go long in foreign currency after the foreign currencyhas appreciated relative to $ by x % above its support
level.
Go short whenever currency falls x % below resistance
level.
Common x % rules - 1%,2 %.
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Use moving averages of exchange rate.
n-day moving averagesample average of last n
trading days including the current rate.
A (y,z) moving average crossover ruleuses averagesover a short period (y days) and over a long period
(z days).
Go long in the foreign currency when the STMA
crosses the LTMA from below. Common rules - (1,5),(1,20),(5,20).
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Extensively used by forex dealers. Inherent problems in fundamental analysis like picking
right exchange rate model, forecasting modelsfundamental variables, non- availability of all
macroeconomic inputs at frequent intervals , poormeasurements
Forward ratenot an unbiased predictor of future spotrate even in efficient market.
Sufficiently large amount of trading world is usingtechnical analysis, demands and supplies will bebuffeted by these irrational traders.
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Involves developing forecasts from market indicators.
Usually, either the spot rate or the forward rate is used,
since speculation should push the rates to the level thatreflect the market expectation of the future exchange
rate.
If no forward markets exists for a particular currency ,nominal interest rates are used
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Refers to the use of a combination of forecastingtechniques.
The actual forecast is a weighted average of the various
forecasts developed.
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3 dimensions to evaluate quality of a forecasts
Accuracy
Forecast error = actual exchange rateforecasted rate
Two measures of accuracy - Mean absolute error and Root
mean squared error
Percentage Correct
Evaluate a forecasting record by finding the % of times
the forecaster was on the correct side of forward rate.
It should be strictly larger than 50 % for the forecasters
services to add value to decision-making process.
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Profitability
Technical forecasters performance is characterized by
relatively small number of successful forecasts in
which large profits are made & a relatively large
number of incorrect predictions in which small losses
are incurred.
Compute profits or losses made based on forecastersadvice & compare those returns to returns onalternative investments that do not require forecasts.