1 Why Firms Forecast XRs Hedging decisions Hedging payables and receivables Shortterm financing decisions Which currency to borrow in Low rate weakening currency 2 Why Firms Forecast XRs Shortterm investment decisions ID: 796613
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Slide1
International Finance
Forecasting Exchange Rates
1
Slide2Why Firms Forecast XRs
Hedging decisionsHedging payables and receivablesShort-term financing decisions
Which currency to borrow in
Low rate, weakening currency
2
Slide3Why Firms Forecast XRs
Short-term investment decisionsWhich currency to park money inHigh rate, strengthening currency
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Slide4Why Firms Forecast XRs
Capital budgeting decisionsAnalysis includes currency conversions for future cash flowsMust assume an XR
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Slide5Why Firms Forecast XRs
Earnings assessmentsShould foreign subsidiary remit earnings to parent, or reinvest in foreign country?
Remit if foreign currency is expected to depreciate
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Slide6Why Firms Forecast XRs
Long-term financing decisionsCurrency of coupon payments for bondsDual currency bonds
Coupon payments in different currency from face value
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Slide7Forecasting Techniques
Technical ForecastingUse of historical XR dataLooks for trends
Tends to focus on near-term future
Not very precise
Patterns may disappear
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Slide8Forecasting Techniques
Fundamental ForecastingBased on relationships between economic variables and XRsInflation rates
Interest rates
Income levels
Government controls
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Slide9Forecasting Techniques
Fundamental ForecastingForecasters study fundamentals of economy to predict economic trendsPlot how past econ events impacted XRs
Use linear regression to forecast
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Slide10Forecasting Techniques
Purchasing Power Parity(1 + Π
D
)
=
S
t+1
= 1+
Δ
S
D/F
(1 +
Π
F
) S
t
Inflation expectations can come from TIPS vs.
T-notes
10
Slide11Forecasting Techniques
Forward RatesMarket-based forecastMust account for bid-ask spread (can be wide
)
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Slide12Forecasting Techniques
Example: $/£
Slide13Forecasting Techniques
Today’s Spot RateExpectations already built into spot rateBest for short-term forecasting
Relies on notion of market efficiency
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Slide14Forecasting Techniques
with Mexican Peso
Slide15Forecast Error
Always will have some errorPotential error is larger forMore volatile currencies
Longer forecast horizon
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Slide16How Forecast Error is Affected by Volatility
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Slide17Forecast Error
Forecast error can have severe consequences for MNCCan turn positive NPV project into negative NPV projectMNC may choose to hedge
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Slide18Forecast Error
Measuring forecast errorAs percentage of realized value
Difference between
Forecasted & Realized
Error =
Value
Value
Realized Value
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Slide19Forecast Error Example
British Pound Mexican Peso
1.50 - 1.35
= 10%
.12 - .10
=20%
1.50 .10
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Forecasted
Value
Realized
Value
British Pound
$1.35
$1.50
Mexican Peso
$.12
$.10
Slide20Types of Forecast Errors
Inaccurate but unbiasedLow r2
Large but random forecast errors
Biased
Predictable forecast errors
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Slide21Forecast Error Example
Slide22Forecast Error Example