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

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,... Chapter 8 Exchange Rate Forecasting, Technical Analysis and Trading Rules Objectives • To explain why exchange rate forecasting is needed • To illustrate forecasting techniques • To explain how to evaluate the performance of forecaster

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  1. Chapter 8 Exchange Rate Forecasting, Technical Analysis and Trading Rules
  2. Objectives • To explain why exchange rate forecasting is needed • To illustrate forecasting techniques • To explain how to evaluate the performance of forecasters  (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-2
  3. 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 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-3
  4. Definition • Forecasting is a formal process of generating expectation • Expectations are implicit forecasts Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-4
  5. Why do we need exchange rate forecasting? • Spot speculation • Uncovered interest arbitrage • Spot-forward speculation • Option speculation • Hedging • Investment and capital budgeting  (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-5
  6. Why do we need exchange rate forecasting? (cont.) • Financing decisions • Pricing decisions • Strategic planning • Macroeconomic conditions • Central bank intervention Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-6
  7. 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 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-7
  8. Single-equation models • The exchange rate (or its rate of change) depends on one or more variables: St f ( X 1,t , X 2,t  X n,t ) St a0 a1 X 1,t a2 X 2,t  an X n,t Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-8
  9. Examples of single-equation models S t a0 a1 ( P P )t S t a0 a1 (i i )t 1 St a0 a1Ft 1 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-9
  10. Problems of single-equation models • The ‘black box’ problem • Forecasting the explanatory variables • Data frequency • Structural changes • Measurement errors • Qualitative variables Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-10
  11. Multi-equation models • The ‘black box’ problem can be solved by specifying a multi-equation model Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-11
  12. Time series models • These are based entirely on the history of the exchange rate: St f ( St 1 , St 2  st n ) St μt γt φt εt  (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-12
  13. Time series models (cont.) • Exchange rates move predominantly in cycles with significant random variation Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-13
  14. Cycles of the US dollar’s effective exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-14
  15. 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 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-15
  16. 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.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-16
  17. Market-based forecasting (cont.) • The reliability of market-based forecasts depends on the validity of the random walk hypothesis and the unbiased efficiency hypothesis Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-17
  18. Spot and lagged forward exchange rates (USD/AUD) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-18
  19. The forward rate forecasting error as a percentage of the spot rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-19
  20. Judgmental forecasting • Judgmental forecasting takes into account all factors affecting exchange rates • It is not based on a formula derived from a formal model Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 8-20
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