© 2018 Cambridge University Press 10-1
Michala Moravcová
Department of Finance, Masaryk University
International Finance
CURRENCY FORECASTING TECHNIQUES
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1. Currency Forecasting Techniques
2. Fundamental Analysis
3. Technical Analysis
Content
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• Fundamental exchange rate forecasting
• Uses fundamentals in econometric models (e.g., money supply, inflation, productivity growth
rates, current account)
• Technical analysis
• Using historical data to find patterns
• Academics criticize it, but a survey suggests this is used often by traders
• This suggests that there might be something to it, especially since other models also have
shortcomings
• Fundamental analysis is flawed as well
• Forward rate may not be an unbiased predictor of the future spot rate, even in an efficient market
• If enough of the trading world uses it, it will matter through trade pressure
1. Currency Forecasting Techniques
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Categories of Exchange Rate Forecasting Techniques
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• Formal economic models of exchange rate determination, which link exchange
rates to macroeconomic fundamentals such as money supplies, inflation rates,
productivity growth rates, and the current account.
• The models involve parameters that govern the relationship between the
exchange rate and the fundamentals. For example, if the current account deficit
as a percentage of gross domestic product (GDP) increases by x %, the model
predicts that the domestic currency will depreciate relative to the foreign
currency by b multiplied by x %. (b is estimated by econometrics models, i.e.
Regression analysis).
Fundamental analysis
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• Evaluating forecasts
• Accuracy
• Mean absolute error (MAE)
• Root mean squared error (RMSE)
• Being on the right side of the forward rate
• Making right decision as to whether to go long or short on currency could be sufficient
• Percentage correct – beat probability and statistics, i.e., 50% chance of being right
• Profitability
• How often can be you be wrong if you lose small when you are wrong and win big when you are
right?
Currency Forecasting Techniques
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• Fancy Foods can seek the advice of two forecasting companies to help it predict
future forex rates: Forexia and Trompe Le Monde. Which forecast is more
accurate?
Currency Forecasting Techniques
Technically more accurate but suggests no hedging, which
proves to be costly: £1𝑀×($1.55 − $1.53)/£ = $20,000
More inaccurate but suggests
hedging, which proves to be less costly
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• The asset market approach to exchange rate determination
• The exchange rate as an asset price – based on current fundamentals and expectations of future
exchange rates
• Just like stocks – linked to current / future fundamentals
• There are two assets (currencies) in FX rate
• The exchange rate as a weighted average of the current fundamental and its expected future value. The
equity price of a stock the value of the current cash flow (the dividend) and the discounted expected
value of the future equity price, the price at which you can sell the stock in the future.
• Even a small change in current fundamentals can cause a large change in the forex rate if it also changes
expectations
• The monetary approach
• Real money balances – people are only concerned with the real value of the nominal money they are
holding
• Depends on income, and on interest rates (money supply) (we compare 2 currencies)
• Currency depreciates: ↑ MS (↓IR) =, ↑ inflation, ↓ real income
• Reasonable in the long-term, questionable in short-term (prices can be sticky)
Fundamental Exchange Rate Forecasting
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• Why the random walk works
• Current exchange rates adequately reflect the expected value of future fundamental values
• In order for this to be true exchange rate should also predict future fundamental values (Engel,
Mark and West, 2007 show this to be true)
• Novel forecasting techniques that efficiently exploit the information across
fundamentals in multiple countries predict exchange rates out of sample better
than the random walk model. At longer horizons, such as 3 to 4 years in the
future, fundamental models do have predictive power for exchange rates (see, for
example, Mark, 1995).
Fundamental Exchange Rate Forecasting
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• News and exchange rates
• The performance of the monetary exchange rate model is that exchange rate changes are
unpredictable but they still reflect news about fundamentals
• If there is news about the money supply or real income, and it does not change the
exchange rate in the required direction, this would be strong evidence against the
fundamentals model. Several authors have used high-frequency data on exchange rates
and macroeconomic announcements to investigate how exchange rates react to
macroeconomic news (see Andersen et al., 2003, 2007; and Faust et al., 2007, Kočenda
and Moravcová, 2019, Moravcová, 2018).
• News is incorporated into exchange rates very quickly (typically less than 15 minutes) – market
efficiency
• Strange reaction to news about inflation/increases in money supply: the dollar appreciates whereas it
should depreciate according to the MER model – one interpretation is that this reaction anticipates
central bank responses of aggressive monetary policies (i.e., higher interest rates)
• Leaking news
Fundamental Exchange Rate Forecasting
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• The real exchange rate, the real interest rate differential, and the Current Account
• Converting UIRP (International Fisher Effect) to real terms
• Alter nominal interest rates using expectation about inflation
• When the foreign interest rate is greater than the domestic interest rate, domestic currency is
expected to appreciate in real terms (UIRP)
• Mean reversion – should always go back to the mean
• Whether the forex rate is unusually high or low in forecasting future forex rates – your best
predictor remains the current forex rate
• Empirical evidence is weak
Fundamental Exchange Rate Forecasting
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EURCZK forecast
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Source: cnb.cz
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The Real Exchange Rate and the Real Interest Differential
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• The real exchange rate and the BOP
• The trade balance (part of the Current Account)
• Strong domestic currencies make foreign goods cheaper
• The Capital Account
• Higher real interest rates (increases savings and decreases real investment) are associated with
capital account deficits (losing net foreign investment)
Fundamental Exchange Rate Forecasting
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• Equilibrium
• Supply and demand force an equilibrium price and quantity of the real exchange rate on the
current account through a “goods” channel and a “savings and investment” channel
• Increase in government spending/decrease in taxes causing a budget deficit increases demand
• à Real interest rates increase
• à Currency appreciates
• New information signals increases in future GDP
• à Consumers spend more
• à Currency appreciates (due to Current Account deficit / inflow of foreign capital)
Fundamental Exchange Rate Forecasting
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• PPP-based forecasts
• Most popular fundamental exchange rate models
• “Fair value” exchange rate models used by most brokers / banks
• They adjust PPP for various effects, such as productivity trends, which is particularly important for
developing countries
• They use the deviation between current value and fair value of the exchange rate to predict the
direction of change
• Academic studies suggest there is some predictive power, though it is limited to medium-tolong
horizons
• For example, the Big Mac index
Fundamental Exchange Rate Forecasting
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• Why to use it?
• Forex dealers and currency fund managers make extensive use of technical analysis (see, for
example, Gehrig and Menkhoff, 2006).
• Fundamental analysis has some inherent problems. (right exchange rate model,
fundamental variables must be forecast, macroeconomic inputs to fundamental
analysis are not all available at frequent intervals).
• Forward rate may not be an unbiased predictor even in efficient market.
• Large segment of the trading world is using technical analysis.
Technical analysis
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• “Pure” technical analysis: Chartism
• Support level – level price has trouble falling below
• Resistance level – level price has trouble rising above
• Breakout – a sudden break of a trading range
• Potentially spurious patterns
• Does charting work?
Technical Analysis
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Exchange Rate
Patterns Described by
Chartists
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• Filter rules
• x% rules
• Buy (go “long”) the currency if it appreciates by x% above its most recent trough (or support level)
• Sell (go “short”) the currency when it falls x% below its most recent peak (or resistance level)
• Moving-average crossover rules
• Go long (short) in the foreign currency when the short-term moving average crosses the long-term
moving average from below (above)
• 1 and 5 days; 1 and 20 days; 5 and 20 days
Technical Analysis
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How Filter Rules Work
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• Non-linear models
• More sophisticated models which take non-linearity into consideration
• Use computer techniques such as algorithms to search for optimal trading rules
• Apply Darwinian-like, natural-selection process to filter rules on past data to breed the “best”
trading rules
Technical Analysis
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• What causes a currency crisis?
• Macroeconomic conditions
• Government follows policies inconsistent with its currency peg – speculative attack is unavoidable
• Government will exhaust reserves defending peg
• Events that should precede devaluations
• Growing budget deficits
• Fast money growth
• Rising wages and prices
• Currency overvaluation
• Current account deficits (caused by budget deficits combined with currency overvaluation)
Predicting Devaluations (Pegged Regimes)
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• Self-fulfilling expectations
• Group of investors begin speculative attack
• Other investors see this and think that the currency will collapse so they convert out of
currency
• Contagion
• If group successfully attacks one currency, they might as well try another
• If one currency is attacked, other currencies will appreciate relative to that currency and their
domestic firms suffer a loss of competitiveness
• Other countries in similar position – obvious targets (e.g., Asian crisis)
Predicting Devaluations
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• How do fundamental analysis and technical analysis differ?
• Describe three statistics you should obtain from a currency-forecasting service
in order to judge the quality of its currency forecasts.
• Does a large increase in the domestic money supply always lead to a
depreciation of the currency?
• What is chartism?
• What is an x% filter rule?
• What is a moving-average crossover rule?
Questions
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