Forecasting Exchange Rates

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Forecasting Exchange Rates

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Title: Forecasting Exchange Rates


1
Forecasting Exchange Rates
2
Last 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

3
Thats 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.

4
Exchange 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.

5
The 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

6
Use 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.

7
Evaluation 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.

8
Absolute Forecast Errors over TimeUsing the
Forward Rate as a Forecast for the British Pound
9
Forecast Bias over Timefor the British Pound
10
Forecast Bias
  • The following regression model can be used to
    test for forecast bias
  • realized value a0 a1 Ft 1 m

11
Graphic Evaluation of Forecast Performance
Region of downward bias (underestimation)
Region of upward bias (overestimation)
12
Graphic 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.

13
Forecast Bias in Different Subperiodsfor the
British Pound
14
The 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
17
Econometric 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

18
Econometric 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?

19
Econometric 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!

20
Meese 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.

21
Frankel 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.

22
Econometric Models Testing
  • However,
  • More sophisticated models exist
  • VARs, Bayesian
  • Most importantly, the really good models never
    get published!

23
The 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

25
Technical 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

26
Technical 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
29
Technical Analysis Other Types
  • Moving Average Crossovers
  • Buy currency when SRMA crosses LRMA going up
  • Sell currency when SRMA crosses LRMA going down

30
Head 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
31
More examples
32
Empirical Evidence
  • Sweeney (1986) uses 1975 to 1980 data
  • Rule is to buy FX if filter rules give a signal
    in, otherwise stay in dollars

33
Empirical 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

34
Data 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.

35
Fancy 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

36
Would 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

37
You 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

38
In 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

39
How about Professional Forecasts?
  • Lets see the track record of professional
    forecasters
  • Before we do, we need some tools

40
Forecast 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
41
Forecast Performance Evaluation
42
Forecast Performance Evaluation
The mean squared error (MSE) and the root mean
squared error, are commonly used to estimate the
average error size. Why squared?
43
Forecast 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

44
Forecast 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

45
Forecast 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.

46
Forecast 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.

47
Forecast 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

48
Forecast Performance EvaluationAccurate versus
Useful Forecasts
  • To measure usefulness, let
  • Then, the test for usefulness is ?
  • According to the binomial distribution

49
Accurate 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.

50
Forecast Performance EvaluationAccurate versus
Useful Forecasts
  • So to evaluate forecasters, we look at both
    accuracy and usefulness

51
The 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

52
Professional 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)

53
Professional 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!)

54
The Final Word We have learned some of the most
popular ways to forecast exchange rates
Using the Forward Rate
1
  • Using Technical Analysis

2
Using Econometric Models
3
55
The 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
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