Lecture Week 5- Foreign Exchange Markets II

 Use of PPP for fundamental forecasting  While the inflation differential by itself is not sufficient to accurately forecast exchange rate movements, it should be included in any fund

Lecture Objectives

forecasts.

use.

put option contracts.

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Part 1:

Forecasting Exchange Rates

Part 1.A

Why Forecasting Exchange Rate?

Why Firms Forecast Exchange Rates? (1 of 3)

 Hedging decisions

 Firms’ decision to hedges receivals or payables is determined by its forecasts of foreign currency values.

 Short-term investment decisions

 Corporations with short-term substantial amount of excess cash make investment decision

 Firms build large deposits in several currencies – with high

interest rate, stronger currencies

 Capital budgeting decisions

 MNC’s parent assesses whether to invest funds in a foreign

project,

 Decision involves cash flow measurement in local currency.

Why Firms Forecast Exchange Rates? (2 of 3)

 Earnings assessment

 The parent’s decision about whether a foreign subsidiary

should reinvest earnings in a foreign country or remit earnings back to the parent may be influenced by exchange rate

forecasts.

 Long-term financing decisions

 MNCs that issue bonds to secure long-term funds may

consider denominating the bonds in foreign currencies.

 MNCs prefer that the borrowing currency depreciate over time

 Forecasts of exchange rates help to estimate the cost of

issuing bonds

Summary - Motives for Forecasting Exchange Rates

Part 1.B

Forecasting Techniques

Forecasting Techniques (2 of 10)

 Technical Forecasting

Involves the use of historical exchange rate data to predict future exchange rate.

 Limitations of technical forecasting:

 Useful for very short-term periods.

 It may work well in one particular period but may not work well

in another period.

 If the foreign exchange market is weak-form efficient then

technical analysis would not be able to improve upon today’s exchange rates when forecasting those rates in the near future.

 Fundamental Forecasting

Based on fundamental relationships between economic variables & exchange rates

 Use of PPP for fundamental forecasting

 While the inflation differential by itself is not sufficient to accurately forecast

exchange rate movements, it should be included in any fundamental forecasting model.

 Fundamental Forecasting with a Lagged Impact

 Fundamental forecasting sometimes has to account for a lagged (delayed) impact,

in which changes in variables in an earlier period spill over to affect exchange rate movements in a later period.

 Instantaneous Influences in Fundamental Forecasting

 The values of independent variables may not be known at the time when the MNC wants to forecast the exchange rate, forecasts for these independent variables

must be used.

Forecasting Techniques (3 of 10)

 Fundamental Forecasting with comprehensive model

 Comprehensive model might include many more factors than are described here, the application would still be similar

 A large time-series database would be necessary to warrant any confidence

in the relationships detected by such a model.

 Change in a currency’s spot rate is influenced by the following factors:

 e f = f (ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP )

where

e f = percentage change in the spot rate

ΔINF = change in the difference between U S inflation & foreign inflation

ΔINT = change in the difference between the U.S interest rate & foreign interest rate

ΔINC = change in the differential between the U.S income level & foreign income level ΔGC = change in government controls

ΔEXP = change in expectations of future exchange rates

Forecasting Techniques (4 of 10)

Accounting for Uncertainty Surrounding Forecasts (5 of 10)

Sensitivity Analysis Applied to Fundamental Forecasting

 Accounts for the possible error in the forecasted value of the factor and

improve its forecasts

 Valuable because it allows the MNC to derive a variety of forecasts

based on alternative scenarios

EXPECTED EXCHANGE RATE MOVEMENT (e f ) IF THIS SCENARIO OCCURS

 Limitation of Fundamental Forecasting

 Forecasts of some factors may be difficult to obtain.

 The precise timing of the impact of some factors on a currency’s value is not known

 Some factors are not easily quantified.

 Regression coefficients may not remain constant.

Forecasting Techniques (6 of 8 )

 Market-based Forecasting

 Using spot rate at time t0 (today) to forecast of the spot rate at time t+1.

 Using forward rate set today to forecast the future spot rate: F = S(1+p)

 Rationale for using the forward rate?

 Forward rate should serve as a reasonable forecast for the future spot rate

 Otherwise speculators would trade forward contracts (or futures contracts)

to capitalize on the difference between the forward rate and the expected future spot rate.

E(e) = expected percentage change in the exchange rate

p = percentage by which the forward rate (F) exceeds the spot rate (S)

Forecasting Techniques (7 of 8 )

 Market-based Forecasting

 Long-Term Forecasting with Forward Rates

 Long-term exchange rate forecasts can be derived from long-term forward rates

 The forward rate is typically more accurate when forecasting exchange rates for short-term horizons than for long-term horizons (typically true for all

forecasting methods!)

 Implications of the IFE for Forecasts

 Since the forward rate captures the interest rate differential (and therefore the expected inflation rate differential) between two countries, it should

provide more accurate forecasts for currencies in high-inflation countries

than the spot rate.

Forecasting Techniques (8 of 10 )

 Mixed Forecasting

 Use a combination of forecasting techniques (Exhibit 9.2)

 Mixed forecast rate is a weighted average of the various forecasted rates under different methods

Forecasting Techniques (9 of 10)

Forecasting Techniques Summary (10 of 10)

The peso's value declined below a specific threshold level in the last few weeks.

The peso's value will continue

to fall now that it is beyond the threshold level.

Fundamental Economic

growth, inflation, interest rates

Mexico's interest rates are high, and inflation should remain low.

The peso's value will rise as U.S investors capitalize on the high interest rates by investing

to Mexico's relatively high interest rates.

Based on the forward rate, which provides a forecast of the future spot rate, the peso's value will decline.

Table: Forecasts of the Mexican Peso using forecasting techniques

Part 1.C

Assessing Forecasting Performance

Assessment of Forecast Performance (1 of 5)

Measurement of forecast error

Forecast errors differs across time horizons

 The potential forecast error for a particular currency depends on the forecast horizon

Forecast errors differs across currencies

 The ability to forecast currency values may vary with the currency of

concern

Comparing Forecast Errors among Forecast Techniques (Exhibit Next)

 MNCs compare the forecast error produced from various techniques used to derive forecasted exchange rates for a particular currency

 Allows firm to be more confident about the rates and the method to relay on

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Assessing Forecast Performance (2 of 5)

• Graphic Evaluation of Forecast Bias

o Forecast bias can be examined with the use of a graph that compares

forecasted values with the realized values for various time periods

• Statistical test of forecast bias

o A conventional method of testing for a forecast bias is to apply the following regression model to historical data.

0 1 1

S = a + a F − +  where

S t = spot rate at time t

F t−1 = forward rate at time t − 1

μ t = error term

a0 = intercept

a1 = regression coefficient

Graphic Evaluation of Forecast Performance

Forecast Time Period

Shifts in Forecast Bias over Time

Because the forecast bias can change over time, refining a

forecast to adjust for a forecast bias detected in the past

is not a perfect solution

Comparison of Forecast Techniques (4 of 5)

Period

Technical Forecasting (TF) (Zloty)

Market-based Forecasting (MBE) (Zloty)

Realized value (Zloty)

Absolute forecast error TF

Absolute forecast error

MBE

Difference in Absolute Forecast Error (TF – MBF)

Sum = 56 Mean = 07

Sum = −.24 Mean = −.03

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Volatility Affects Forecast Error – How? (5 of 5)

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• Why forecasting volatilities?

 Higher volatilities leads to higher forecast error and vice-versa

• Methods of forecasting volatilities:

 Using recent levels of volatility

 Using historical patterns of volatilities

 Using implied standard deviation

Part 2:

Currency Derivatives

Part 2.A

Currency Derivatives Basics

Currency Derivative? (1 of 2)

 A currency derivative is a contract whose price

is derived from the value of an underlying

currency.

 Examples include forwards/futures contracts and options contracts.

 Derivatives are used by MNCs to:

• Speculate on future exchange rate movements

• Hedge exposure to exchange rate risk

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Currency Derivative - Positions? (2 of 2)

 If you have agreed

Part 2.B

Forward Market & Forward

Contract

Forward Market & Forward Contract (1 of 4)

contracts on currencies.

MNCs/corporation and a financial institution:

 To exchange a specified amount of currency

 At a specified exchange rate (the forward rate)

 On a specified date in the future

the MNCs

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How MNCs Use Forward Contracts?

• Set up forward contracts to lock in the exchange rate to

hedge imports /exports (payment and receipts)

• Forward contracts are often valued at $1 million or more

• Usually not used by consumers or small firms

Quotations on Forward Rates

• Like spot rates, there is a bid/ask spread on

forward rates

• Bid/Ask Spread is wider for less liquid

currencies.

• F = S(1 + p)

• If F>S; forward rate contains a premium

• If F< S; forward rate contains a discount

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where:

F is the forward rate

S is the spot rate

p is the forward premium (discount), or the % by which the

forward rate differs from the spot rate

Annualized Forward Rate Premiums (Discounts)

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𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝒑𝒓𝒆𝒎𝒊𝒖𝒎 𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝒑 = 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝒓𝒂𝒕𝒆 − 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆

𝟑𝟔𝟎 𝑴𝒂𝒕𝒖𝒊𝒓𝒕𝒚 (𝒏)

Arbitrage — The forward rates typically differ from the spot rate for any

given currency or maturity, creating arbitrage opportunity

Forward Market (4 of 4)

 Movements in the Forward Rate over Time:

differential between the two countries and can change over time.

 Offsetting a Forward Contract

the original counterparty bank.

 Using Forward Contracts for Swap Transactions

Part 2.B1

Forward Market:

Non-deliverable Forward Contract (NDF)

Non-Deliverable Forward Contracts (1 of 3)

Non-deliverable forward contracts (NDF)

 A NDF is a special type of forward contract where

the contracting parties do not exchange the original amount to hedge the underlying position rather, they exchange the balancing amount to hedge any

currency position

 Can be used for emerging market currencies where

no currency delivery takes place at settlement

Non-Deliverable Forward Contracts (2 of 3)

Non-deliverable forward contracts (NDF) - Example

• Müller AG Limited, a Thailand based MNCs has purchased a

NDF of amount US$ 100,000 from SB Bank to settle one of its payables with a US MNC

• The forward rate is Baht 12.50 per US$ The term of maturity is

6 months

• At maturity sport rate stands at $1 = 15.00 Baht

• Questions:

• What the amount of delivery either in the form of receivables or

payables that the company or bank should have to settle the

NDF?

• How about $1 is traded at Baht 10.00 at maturity?

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Non-Deliverable Forward Contracts (3 of 3)

Non-deliverable forward contracts (NDF) - Example

• When spot rate $1=15.00 Bath:

− Müller AG will buy $100000 @ 15.00 Baht/$ from the market

− The cost of the payables will be = $100000 * 15.00 Baht = 15,00,000 Baht

− Thus, SB bank must pay to the Müller AG to hedge its payable

− The amount of payment to Muller AG = (15.00 – 12.50) * $100000 =

250,000 Baht

• When spot rate $1=10.00 Bath:

− Müller AG will buy $100000 @ 10.00 Baht/$ from the market

− The cost of the payables will be = $100000 * 10.00 Baht = 10,00,000 Baht

− Thus, Müller AG must pay SB bank to hedge its payable

− The amount of payment to SB bank = (12.50-10) * $100000 = 250,000

Baht

Part 2.C

Future Market & Future Contract

Currency Futures Market (1 of 8)

 The currency future market facilitates the trading of future contracts on

currencies

 A future contract is an agreement between a MNCs/corporation and a financial institution to exchange:

 A specified amount of currency

 At a specified exchange rate (the future rate)

 On a specified date in the future

 Standardized features:

 Large contract size i.e., 125,000 Euro per unit

 Delivery month - Third Wednesdays in March, June, September, and

December

 Daily resettlement - Offer greater liquidity than forward

 If the price goes down, the long pays the short

 If the price goes up, the short pays the long

Currency Futures Contracts (2 of 8)

CURRENCY UNITS PER CONTRACT CURRENCY UNITS PER CONTRACT

Australian dollar 100,000 Japanese yen 12,500,000

Brazilian real 100,000 Korean won 125,000,000

British pound 62,500 Mexican peso 500,000

Canadian dollar 100,000 NZ dollar 100,000

Chilean peso 50,000,000 Norwegian krone 2,000,000

Chinese yuan 1,000,000 Polish zloty 500,000

Czech koruna 4,000,000 Russian ruble 2,500,000

Euro 125,000 South African rand 500,000

Hungarian forint 30,000,000 Swedish krona 2,000,000

Indian rupee 5,000,000 Swiss franc 125,000

Israeli shekel 1,000,000 Turkish lira 1,000,000

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 Contact size: Based on Chicago Mercantile Exchange (CME)

Currency Futures Market (3 of 8)

Trading Currency Futures

• Firms or individuals can execute orders for currency futures contracts by

calling brokerage firms.

Trading platforms for currency futures:

• Electronic trading platforms facilitate the trading of currency futures These

platforms serve as a broker, as they execute the trades desired.

Credit Risk of Currency Futures Contracts —

• No credit risk - future contracts are guaranteed by the exchange

clearinghouse (CME)

• To minimize its risk, the CME imposes margin requirements to cover

fluctuations in the value of a contract (more in tutorials)

Pricing Currency Futures

• The price of a currency futures contract is like the forward rate for a given

currency and settlement date,

• The price differs from the spot rate when the interest rates on the two

currencies differ.

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Use of Currency Futures Market (4 of 8)

 How Firms Use Currency Futures?

 Purchasing Futures to Hedge Payables — The purchase of

futures contracts locks in the price at which a firm can purchase a

currency.

 Selling Futures to Hedge Receivables — The sale of futures

contracts locks in the price at which a firm can sell a currency.

 Speculator Use of Currency Future

 Speculator aims to gain form pricing movement by undertaking

counter position to close out the position

 Closing Out a Futures Position

 Sellers (buyers) of currency futures can close out their positions by

buying (selling) identical futures contracts prior to settlement

 Most currency futures contracts are closed out before the settlement

date

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