Assignment of

International Financial Management

On
Currency Forecasting-Need & technique

Submitted by: Submitted to:

Afrin Ashraf Mrs. Sana Beg

Bhavana Kumari

Faraz Iliyas
 CURRENCY FORECASTING

As the name suggests, currency forecasting refers to the ability to predict the
long-term value and price of a currency.

Currency  Forecasting is an important resource in the quest to develop a better

understanding of the diverse forces which influence rates of currency exchange
throughout the world.

To provide a framework for effective decisions in this complex field, a good

currency forecasting system needs to keep the operator informed with respect to
both the world markets and intricate other factors that cause currency
fluctuations. Foreign exchange markets are influenced by changing relationships
between countries and also internal situations such as the state of economies and
changes of Governments. Even climatic variations have been shown to cause
currency fluctuations.
 NEED FOR FORECASTING

Various aspects of operations are influenced by changes in exchange rate. Thus,

companies need foreign-exchange forecasts for many of its corporate functions.
Although future exchange rate are not easy to forecast.

With the help of currency forecasting we can:

 Reduce currency levels 20 to 40 percent

 Increase currency availability and customer service levels

 Optimize transportation schedules and costs

 Map historical trends and special events with sophisticated, automated

forecasting

 Reduce currency outages and expensive emergency deliveries

 Manage currency order and deposit operations for retail customer

Hedging Decision:

MNCs have a variety of foreign-currency denominated payables, receivables,

credit purchases, credit sales, and uncovered forward contracts. These payables
and receivables are exposed to foreign exchange risk due to unexpected change in
the future exchange rate. Companies’ decision to hedge against these potential
losses may be determined by the forecast of currency.
Working capital method:

Working capital management consists of short-term financing and short-term

investment decisions.

The value of the currency borrowed or invested will change with respect to the
borrower’s or the investor’s local currency over time.

When MNCs borrow, they have access to a variety of sources in a variety of

currencies. They should choose the one with a low interest rate and whose
currency will depreciate over the life of the loan.

Additionally, large short-term loans should be spread across a number of

different currencies.

Long term investment management & financing decision:

An important feature of long-term investment analysis is that the projected cash

flows depend partially on future exchange rates. More accurate predictions of
exchange rate movements will result in more accurate cash flow predictions and
better company decision-making. Investors should invest in a currency that will
have a high rate of return and appreciate over the investment period.

When MNCs issue bonds to obtain long-term funds, they should denominate the
bonds in a currency that will depreciate in value over the life of the bond.

Other need:

To assess foreign subsidiary earnings.

To buy or sell a product in a foreign currency.

 TECHNIQUE OF FORECASTING

Just as there are a number of factors affecting currency valuations, there are perhaps
even greater numbers of techniques available to forecast currencies – this keeps the
‘Quants’ in business. Given that we have several unknowns, and that none of us have a
crystal ball gazing into the future, it is clear that some form of statistical technique is
likely to be a good starting point.

There are two approaches to predicting price changes. The first is  fundamental
analysis. The second is technical analysis. However, technical analysis is more useful
for developing trading strategies that predict future price movements.

FUNDAMENTAL ANALYSIS :

Fundamental analysis is a currency forecasting technique that uses fundamental

relationships between economic variables and exchange rates.

The economic variables used include inflation rates, national income growth, changes
in money supply, and other such macroeconomic variables.

It is now typically done through computer based econometric models.

Comparing the employment reports from two countries and making a trade based on
that information would be an example of using fundamental analysis.

Fundamentalists are also attempting to forecast market behavior and then predict how
a currency will respond in such a market environment. To do so, fundamental traders
also develop models from which to formulate a trading strategy.
Currency Forecasting Models

Fundamental traders will use models to examine currency values. (Remember,

technical traders do not employ this method, but rather use trading systems .) This
method of developing models of currency forecasting is used by analysts of major
banks and financial institutions to examine market conditions and forecast currency
values. There are basically seven major models for forecasting currency prices. They
are:

 Balance of Payments Model

 Purchasing Power Parity Model

 Interest Rate Parity Model

 Monetary Model

 Real Interest Rate Differential Model

 Asset Market Model

 Currency Substitution Model

The simplest form of fundamental analysis uses the Theory of Purchasing Power
Parity.

The PPP theory states that equilibrium changes in the exchange rate to changes in the
ratio of domestic and foreign prices.

The formula is :
2
( 1+ I d )
e 1= t
( 1+ I f )
Where et = the dollar price of unit of foreign currency in period t;

eo = the dollar price of one unit of foreign currency in period 0;

Id = the domestic inflation rate; and

If = the foreign inflation rate.

A multiple regression is a more sophisticated approach to forecasting where a
systematic effort is made at uncovering functional relationships between a set of
independent (macroeconomic) variables and a dependent variable (the exchange rate).

Consider a case where a US company forecasts the percentage change in the British
pound (PP) using three variables:

-Inflation differentials (I),

-Differentials in the rate of growth in money supply (M), and

-Differentials in national income growth rates (N).

The formula used would be:

PP = bo +b1I + b2M + b3N +

Where bo, b1, b2,b3, are regression coefficients and : is an error term.

Fundamental analysis is used to varying degrees by nearly every trader. However,

Forex traders rely primarily on technical analysis in their currency forecasting. Still,
most Forex traders will watch for the nonfarm payrolls report , which is released on
the first trading day of every month.

Other traders will rely on a wide array of economic reports to determine the demand
(or price movement) of a currency. Every trader decides which reports are most useful
for the type of currency trades entered.

Fundamental analysis is an important part of learning to understand the markets. In

the short run, the results are not always straight forward, they can even seem
backwards. In the long run, currencies will always move along with fundamentals.
Learning to use fundamental analysis will help you to understand the reasons behind
trends and give you insight into currency movements.
TECHNICAL ANALYSIS:

Technical analysis has long been used in traditional markets like the stock market. Its
methods rely on price history in order to predict the future. Technical analysis is a
currency forecasting technique that uses historical prices or trends. This focuses solely
on past prices and volume movements not on economic and political factors. The
approach is to sell or buy certain currencies if their prices deviate from past patterns.

Charting is one type of technical analysis where forecasters use charts to find peaks and
troughs in the price series and then use these to signal up and down trends. It provides
a lot of information about the price movement of a currency pair.

Mechanical rules are a type of technical analysis where a set of rules is used to help
make this subjective process more disciplined.

Local peaks are called resistance levels and local troughs are called support levels. It
tells where and how the currency price is likely to move. A support line lies below the
currency pair price. A resistance line lies above the currency pair price. Depending on
the strength of these lines, prices tend to trade between the support and resistance
levels, bouncing off one and heading towards the other. 

A filter rule suggests that investors buy a currency when it rise more than a given
percentage above it support level and then sell a currency when it falls more than a
given percentage below its resistance level.

A market-based forecast uses market indicators to forecast exchange rates based on the
concept that these market indicators efficiently incorporate expected future currency
changes.

MNCs often track changes in the spot rate and then use these changes to estimate the
future spot rate. MNCs also often assume that the current forward rate is a consensus
forecast of the spot rate in the future.

The forecasting of forward rates is limited to about one year.

Uses interest rate differential to predict exchange rates beyond one year.

The formula to use is:

t
( 1+id )
e t =e o ×
( 1+if )t
Where et = the dollar price of one unit of foreign currency in period t;

eo = the dollar price of one unit of foreign currency in period 0;

Id = the domestic interest rate; and

If = the foreign interest rate.

Measuring forecast error can be done using the formula:

( FV −RV )2
RSE=
√RV
Where RSE = the root square error as a percentage of the realized value;

FV = the forecasted value; and

RV = the realized value.

A forecasting model is more accurate than the forward rate if it has smaller RSE.

Technical analysis provides information on the best entry and exit points for a trade.
On a chart, the trader can see where momentum is rising, a trend is forming, a price
is dipping or other events are developing that show the best entry point and time for the
most profitable trade. With the constant movement of various currencies against each
other in the Forex market, most traders will focus on using technical indicators to find
and place their trades.

However technical analysis applies can be different for each trader. Every trader has
their own interpretation of where they see trends and support. They also have their
own ideas on setting up their indicators. These differences are called having your own
trading system. You can take 10 different traders and you will probably get 10 different
systems that give different signals. These differences are what make a market work.
Technical analysis is very useful in forex trading. It makes up only one portion of what
you need to know when trading, but it is a very important thing to learn.
Understanding technical analysis will give the charts some meaning when you look at
them and help you understand why certain price movements occurred.

An unfortunate conflict has developed between traders. Some traders believe that
fundamental analysis is more important because it considers the net demand for a
currency. Other traders believe that technical analysis is more important because it
analyzes the price momentum of a currency pair and can accurately pinpoint the entry
and exit points for a Forex trade.

A trader does not need to choose only one approach. Most experienced traders report
that a combined approach to predicting the price movement of a currency pair (using
both technical and fundamental analysis) provides the most accurate results.