Lecture International finance: An analytical approach (3/e): Chapter 8 - Imad A. Moosa

Chapter 8 - Exchange rate forecasting, technical analysis and trading rules. The objectives of this chapter are: To explain why exchange rate forecasting is needed, to illustrate forecasting techniques, to explain how to evaluate the performance of forecasters,...

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Chapter 8

Exchange Rate Forecasting, Technical Analysis and Trading

Rules

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Objectives

• To explain why exchange rate forecasting is needed

• To illustrate forecasting techniques

• To explain how to evaluate the performance of

forecasters

(cont.)

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa

Slides prepared by Afaf Moosa

Objectives (cont.)

• To demonstrate how technical analysis is used to

generate buy and sell signals

• To explain how filter rules and moving average rules work

8-3

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Why do we need exchange rate

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Why do we need exchange rate

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Econometric forecasting models

• These are models that are specified on the basis of economic theory and estimated by an econometric method

• They are classified into single-equation and

multi-equation models

8-7

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Single-equation models

• The exchange rate (or its rate of change) depends

on one or more variables:

t n n t

t t

t n t

t t

X a X

a X

a a

S

X X

X f

S

, ,

2 2 ,

1 1 0

, ,

2 ,

(



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Examples of single-equation models

1 1

0

1 1

0

1 0

) (

t t

F a a

S

i i a a

S

P P

a a

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Problems of single-equation models

• The ‘black box’ problem

• Forecasting the explanatory variables

• Data frequency

• Structural changes

• Measurement errors

• Qualitative variables

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Multi-equation models

• The ‘black box’ problem can be solved by specifying

a multi-equation model

8-11

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Time series models

• These are based entirely on the history of the

exchange rate:

t t

t

n t t

t t

S

s S

S f S

ε φ

γ μ

) ,

( 1 2 

(cont.)

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Time series models (cont.)

• Exchange rates move predominantly in cycles with significant random variation

8-13

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Cycles of the US dollar’s effective exchange rate

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Problem with time series models

• If the FX market is weakly efficient, the exchange

rate must follow a random walk Hence, it is not

possible to forecast the exchange rate based on its history

8-15

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Market-based forecasting

• Using the current market spot and forward rates as

forecasters for the future spot rate

• This means that market-based forecasts are free

and readily available

(cont.)

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Market-based forecasting (cont.)

• The reliability of market-based forecasts depends on the validity of the random walk hypothesis and the

unbiased efficiency hypothesis

8-17

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Spot and lagged forward exchange rates (USD/AUD)

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The forward rate forecasting error

as a percentage of the spot rate

8-19

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Composite forecasting

• Composite forecasting is based on two or more

forecasts that are derived independently

• Forecasting accuracy can be increased by pooling

different forecasts

8-21

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Combining forecasts

k k c

c c

S S

S

S w S

w S

S

S S

ˆ β

ˆ β ˆ

ˆ ˆ

ˆ

2

ˆ

ˆ ˆ

1 1

2 2 1

1

2 1



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Why composite forecasting?

• Different forecasters have different degrees of

forecasting accuracy

• Diversification reduces the risk of large forecasting errors

8-23

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Forecasting performance evaluation

• Performance out of sample is more meaningful

• The loss function is important

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Measures of forecasting accuracy

• Mean absolute error (MAE)

• Mean square error (MSE)

• Root mean square error (RMSE)

8-25

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Magnitude versus direction

• Sometimes it is more important to predict the

direction rather than the magnitude of the change

• The prediction-realisation diagram can be used to

represent magnitude and direction errors

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The prediction-realisation diagram

G C

F

B A H

Line of perfect forecast

Forecast change Actual change

8-27

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Rationale for technical analysis

• Exchange rates are determined by supply and

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A bar chart

Closing High

Low

S

Time

8-31

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Chart formations

• Chartists study charts of exchange rate movements

to identify certain patterns

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Trendlines and trading ranges

• Trendlines connect ascending bottoms and

descending tops

• The market is in a trading range when the tops and bottoms are at the same level

8-33

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Trendlines and trend channels

S

Time (a) Upward trend (bull market) (cont.)

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market)

8-35

(cont.)

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Support and resistance levels

• A support level is the bottom of a market swing

• A resistance level is a point where the market peaks and the exchange rate reverses an upward move

8-37

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Flags

• A flag is a continuation pattern

• A flag occurs when a major trend is interrupted

8-39

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• An ascending triangle appears when buyers come to the market at progressively higher levels Otherwise

it will be a descending triangle

• A symmetrical triangle is difficult to interpret

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Head and shoulders

• This formation indicates the reversal of an upward

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Head and shoulders (cont.)

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Reverse head and shoulders

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Market efficiency and trading rules

• Market efficiency implies that it is not possible to

make profit by adopting a mechanical trading rule or

by following buy-sell signals extracted from charts

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Filter rules

• An x% filter rule means that a currency is bought

when it appreciates by x% from the most recent

trough and is sold when it depreciates by x% from

the most recent peak

8-45

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A single moving average rule

• A single moving average rule means that a currency

is bought when the moving average cuts the

exchange rate series from above and is sold

otherwise

(cont.)

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Double moving average rule

• A double moving average rule says that a buy

signal is indicated when the long moving average

crosses the short moving average from above, and vice versa

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