Title: Forecasting Exchange Rates
1Forecasting Exchange Rates
2Last Topic Market Efficiency
- A capital market is said to be efficient if
prices in the market fully reflect available
information. - Weak, semi-strong, strong
- How to test for market efficiency
- Evidence for Stocks Not very clear
3Thats Stocks, how about Forecasting Exchange
Rates?
- Exchange Rates are a factor in almost every
international financial market decision - For most countries, the exchange rate is the
single most important price in the country - Academic economists have studied exchange rates
intensely for the last 30 years. - Economists at banks, securities firms, and
elsewhere are also devoted to analyzing the
variables that might impact foreign exchange
rates. Recall daily trading is almost US2
trillion.
4Exchange Rate Forecasting
- First off Who would want to forecast exchange
rates? - Investors, corporations, government officials,
etc. - Forecasts play a fundamental role in nearly all
of international finance - The big debate Can we do it? (forecast FX rates)
- While many business and financial decisions
depend on FX forecasts, there is considerable
debate about the possibility of making accurate
or useful forecasts. - Lets see what you think.
5The 3 options to Forecast Exchange Rates
- Use the Forward Rate
- If markets are efficient, the Forward Rate
incorporates all relevant information. That is,
U.I.P holds
6Use the Forward Rate
- Advantages
- Easy to obtain
- Cheap (free, just call a bank)
- Disadvantages
- Most empirical evidence is against the Forward
Rate Unbiased Parity Condition - Even if it is good, you cant profit from it.
7Evaluation of the Forward Rate Performance
- One popular measure, the absolute forecast error
as a percentage of the realized value, is defined
as - forecasted value realized value
- realized value
- If the forecast errors are consistently positive
or negative over time, then there is a bias in
the forecasting procedure.
8Absolute Forecast Errors over TimeUsing the
Forward Rate as a Forecast for the British Pound
9Forecast Bias over Timefor the British Pound
10Forecast Bias
- The following regression model can be used to
test for forecast bias - realized value a0 a1 Ft 1 m
11Graphic Evaluation of Forecast Performance
Region of downward bias (underestimation)
Region of upward bias (overestimation)
12Graphic Evaluationof Forecast Performance
- If the points appear to be scattered evenly on
both sides of the perfect forecast line, then the
forecasts are said to be unbiased. - Note that a more thorough assessment can be
conducted by separating the entire period into
subperiods. - In general, most evidence is against the forward
rate as a good predictor of the future spot rate.
13Forecast Bias in Different Subperiodsfor the
British Pound
14The 3 options to Forecast Exchange Rates
- Use Econometric Models (Fundamental Approach)
- Example A Supply and Demand Model
-
15- Where
- S log of the spot rate (US/FC)
- M US and Foreign Money Supply
- Y US and Foreign Real Incomes
- i US and Foreign nominal interest rate
16- The Model Predicts
- Recall S(US/FC)
- As US money supply increases, the
- As US income increases, the
depreciates
appreciates
If US interest rate gt Foreign interest rate, then
the dollar
depreciates
17Econometric Models
- Other variables have been found to indicate the
direction in a currency - Balance of Payments
- Size of Reserves
- These could be added to the model
18Econometric Models Drawbacks
- They Assume Stationary!
- Often structural breaks interrupt the stability
and stationary of exchange rates Changes in
exchange rate pegs, changes government
intervention policy, realignments (Euro,
East-West Germany unification). - Independent variables are forecasts!
- May be as hard to forecast as S
- Parameters (bs) are measured with imprecision
(standard errors), which may affect forecasts of
S. - So. How good are they?
19Econometric Models Testing
- Meese and Rogoff (1983) find that even with full
knowledge of future independent variables, their
models perform worse than a simple random walk
model!
20Meese and Rogoff (1983)
- Economists do not yet understand the
determinants of short- to medium-rum movements in
exchange rates. models of exchange rates base
on macroeconomic fundamentals cannot explain
exchange rate movements better than a naïve
alternative such as a random walk . Worse yet,
exchange rates are hard to explain after the
fact, even with the knowledge of actual
fundamental variables.
21Frankel and Froot (1990) (Two Famous Economists)
also note
- It is widely accepted that standard observable
macroeconomic variables are not capable of
explaining, much less predicting ex ante, the
majority of short-term changes in the exchange
rate.
22Econometric Models Testing
- However,
- More sophisticated models exist
- VARs, Bayesian
- Most importantly, the really good models never
get published!
23The 3 options to Forecast Exchange Rates
- Technical Analysis
- Technical Analysis is the science/art of of
recognizing systematic patterns in historical
exchange rates - According to technical analysts, these patters
will occur again (history will repeat itself) - When you see a pattern emerge, you know what to
do (buy or sell) - The trend is my friend.
24 Technical Analysis Cont.
- Based solely on historical prices
- Extrapolates past trends in prices (i.e.
technical), does not use fundamentals - Creates buy/sell signals rather than an exchange
rate forecasts - Techniques employed range from the simple to very
complex
25Technical Analysis Signals
- When there is a buy signal, you revert your
position to a long - Buy to even out short position and buy even more
to get a long position - When there is a sell signal, you revert your long
position to a short - Sell long position and go short
- When there is no signal you hold
26Technical Analysis Filter Rules
- Based on changes in Spot Rates since the last
local minimum or maximum - When rates increase by more than X, signal to
buy - When rates decrease by more than Y, signal to
sell
27/Euro
-Y
The rule works here BltS
S
B
X
Time
28/Euro
The Whipsaw! Buy high Sell low
-Y
B
S
X
Time
29Technical Analysis Other Types
- Moving Average Crossovers
- Buy currency when SRMA crosses LRMA going up
- Sell currency when SRMA crosses LRMA going down
30Head and Shoulders
From the sales pitch The "head and shoulders"
pattern is bearish because it often indicates the
end of an uptrend by forming a "lower high" on
the right shoulder. After the neckline is broken,
the projected downward move of ICF is typically
equal to the distance from the top of the head
down to the neckline. In this case, that equates
to a projected downside target of around 63 (7
points below the neckline of 70). Obviously, it
could easily take several weeks or more for this
to occur, but patient traders will be rewarded if
the pattern follows through to the downside
31More examples
32Empirical Evidence
- Sweeney (1986) uses 1975 to 1980 data
- Rule is to buy FX if filter rules give a signal
in, otherwise stay in dollars
33Empirical Evidence
- The filter rules generate about 1-2 profit, even
after transactions costs - The 1 filter rule appears to generate
statistically significant profits - Other studies confirm this for other types of
technical analysis in currencies (not stocks) - However, have to worry about data mining
34Data Mining?
- AKA He who mines data may strike fool's gold !
- Its always possible to explain the past using
technical analysis (sunspots, miniskirts, etc) - An infamous example, David Leinweber went
searching for random correlations to the SP 500.
He sifted through a United Nations CD-ROM and
discovered that historically, the single best
predictor of the Standard Poor's 500-stock
index was butter production in Bangladesh. - What is the hard part is picking the rule that
will work in the future.
35Fancy Mathematical Models
- Many companies offer fancy mathematical models
that can forecast exchange rates - They offer the modes for a price
- Is it worth paying the price?
- No!
- Lets think about this
36Would YOU Sell?
- Suppose you invent a model that can forecast
exchange rates correctly - Suppose further that these models work Make a
profit - Would You sell the model?
- No Way You could make a lot more by keeping it a
secret and speculating in the foreign exchange
market
37You should Not Buy
- Once a model is sold, it becomes public knowledge
and investors revise their expectations
accordingly - This will cause prices to adjust in a way that
profit opportunities disappear - If someone wants to sell a model, it must be
because it cant be used to make a profit - You should not buy
- http//www.forecastingsystems.com/2003/Forecaster.
2.1.htm
38In Reality
- More and more technical analysts appear every day
- A survey revealed that in 1990 almost 90 of all
participants in the London forex market used some
kind of technical model in forming short run
expectations - As the horizon increases, traders put more weight
on economic fundamentals - In the long run, everyone seems to agree that
economic forces determine exchange rates
39How about Professional Forecasts?
- Lets see the track record of professional
forecasters - Before we do, we need some tools
40Forecast Performance Evaluation
- The traditional econometric approach begins with
the forecast error made at time t
Where is the j-period ahead
forecast made at time t is the actual spot
rate at time t j
41Forecast Performance Evaluation
42Forecast Performance Evaluation
The mean squared error (MSE) and the root mean
squared error, are commonly used to estimate the
average error size. Why squared?
43Forecast Performance Evaluation
- The MSE of the forecaster is compared to the MSE
of a naive model (the Homer Simpson Forecaster) - For example, the forward rate
- The model with the lowest MSE wins
44Forecast Performance EvaluationAccurate versus
Useful Forecasts
- It is important to distinguish between accurate
forecasts and useful forecasts. - Accurate forecasts have small forecasting errors
gauged by traditional statistical measures (MSE),
while - Useful forecasts are those on the right side of
the market, leading to profitable speculative
positions and correct hedging decisions. - What about a forecast that is relatively
accurate, but not useful? - Leads to to incorrect decisions
45Forecast Performance EvaluationAccurate versus
Useful Forecasts
- In the absence of a currency risk premium, the
right side of the market implies the right
side of the forward rate.
46Forecast Performance EvaluationAccurate versus
Useful Forecasts
- In the absence of a currency risk premium, the
right side of the market implies the right
side of the forward rate.
47Forecast Performance EvaluationAccurate versus
Useful Forecasts
- If, in fact, the forward rate reflects a risk
premium, then we expect an advisory service
forecast to outperform the forward rate
48Forecast Performance EvaluationAccurate versus
Useful Forecasts
- To measure usefulness, let
- Then, the test for usefulness is ?
- According to the binomial distribution
49Accurate versus Useful Forecasts Intuition
- Suppose you examine 8 different advisory services
and see that, in fact, one of the eight has done
a great job (three quarterly forecasts in a row)
at making correct forecasts. - Does this tell you to go with this forecaster?
- Another way, suppose you get eight Monkeys to
flip a coin, what is the chance that one will
flip heads three times in a row? - Each one has a 1/8 chance, so changes are good
one will get it right three times in a row.
50Forecast Performance EvaluationAccurate versus
Useful Forecasts
- So to evaluate forecasters, we look at both
accuracy and usefulness
51The Professionals
- Levich (1982) evaluated the track record
forecasters over 1977-1980, using monthly
forecasts - The analysis covers 13 forecasters, nine
currencies, four horizons and 48 separate monthly
forecasts, generating over 11,000 individual
forecasts to examine. - More recent updates give similar results
- http//faculty.cox.smu.edu/dmiller/F6214/6214_cla
ss_files/Levich1982.pdf
52Professional Forecasters Review
- Some firms appear to do better that others, but
this could be due to chance and/or the large
sample - Even if some were to firms display skill, this
may not persist over time (people move, models
change)
53Professional Forecasters Review
- Overall Performance
- Most firms had accuracy score above 1, which is
poor. - In fact, only 30 do better than forward rate!
- Many had correctness score below 50, which is
poor (Professionals worse than coin flip!)
54The Final Word We have learned some of the most
popular ways to forecast exchange rates
Using the Forward Rate
1
2
Using Econometric Models
3
55The Final Word We have learned some of the most
popular ways to forecast exchange rates and how
to evaluate them
1
Good forecasting methods may exist, but would you
expect them to be for sale?
Not surprisingly, most professional FX services
do a poor job
2