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What you need to know about exchange rate forecasts
|There is no reliable method available to forecast exchange rates. Paul Krugman and Maurice Obstfeld write in their book “International Economics: Theory and Policy” (New York, HarperCollins:1994): If exchange rates are asset prices that respond immediately to changes in expectations and interest rates, they should have properties similar to those of other asset prices, for example, stock prices. Like stock prices, exchange rates should respond strongly to “news,” that is, unexpected economic and political events; and, like stock prices, they therefore should be very hard to forecast. In a study by Richard M. Levich (“Evaluating the Performance of the Forecasters”, in: Donald R. Lessard, ed., “International Financial Management”, New York: John Wiley:1985, pp. 218-233) in which he surveyed the track record of a dozen exchange rate forecasting companies through 1982 he found little evidence that professional forecaster do systematically better than an individual who, for example, uses the three month forward rate. That does not imply that forward rates are good predictors. In fact, they usually do not predict exchange rate movements very well.
How are exchange rates determined?
|Long term movements are driven by fundamental forces, such as purchasing power parity. In the short run, exchange rate movements are driven by news and events. For excellent surveys of exchange rate theory see:
• Richard Baillie and Patrick C. McMahon: The foreign exchange market: theory and econometric evidence. Cambridge University Press, New York, 1989.
• Lawrence S. Copeland: Exchange Rates and International Finance. Addison-Wesley, Reading/Mass., 1990.
• Christian Dunis and Michael Feeny (editors): Exchange Rate Forecasting. Woodhead-Faulkner, New York, 1989.
• Peter Isard: Exchange Rate Economics. Cambridge University Press, Cambridge, 1995.
• Ronald MacDonald and Mark P. Taylor: Exchange Rate Economics: A Survey. IMF Staff Papers, 39(1), 1-57.
If exchange rate forecasts are not reliable, why bother?
|As pointed out above, economists do not possess reliable methods of forecasting exchange rates over short time horizons such as days or weeks. Fundamental economic forces (such as purchasing power parity and balance-of-payment disequilibrium) usually take much longer, often several years, to have an effect on exchange rates. Nevertheless, the business community has to form expectations about the short-term trends of exchange rates. Because these expectations are formed by market sentiment, trends can be extrapolated. At the same time, market sentiments can change as financial news can change the outlook on a country’s economic prospects. The PACIFIC Exchange Rate Service provides two sets of exchange rates trends using two different “technical” trending techniques for 30-day and 60-day intervals. Trends based on economic fundamentals (usually for quarterly or annual projections) are usually obtained through large structural computational models, such as the FOCUS model of the Policy and Economic Analysis Program at the University of Toronto. The PACIFIC trends are intended to reveal market trends, not fundamental determinants. Users of the trend charts are advised to read them with considerable caution.
How the trends were calculated
|The diagrams below show 60-day trends and 30-day trends for the Canadian Dollar vis-à-vis four major currencies: the US Dollar, the German Mark, the Japanese Yen, and the British Pound. Understand that these trends are not forecasts. They do not predict the future; they only visualize current trends that can be broken at any time due to the arrival of new information.
In the 60-day trend diagrams, the solid blue line describes the trended path of the exchange rate, and the light blue area describes the 95% confidence interval. The method used in the trends is a combined quadratic trend model and autoregressive model, called a stepwise autoregressive method. The trend component is supposed to capture long-term behaviour, while the autoregressive component is supposed to capture short-term behaviour. The autoregressive parameters included in the model for each series are selected by a stepwise regression procedure, so that autoregressive parameters are only included at those lags at which they are statistically significant. Since the trend and autoregressive parameters are computed in sequence rather than simultaneously, there are objections against this method on a theoretical level. However, the trends are computationally inexpensive. The computations are carried out using PROC TREND in the SAS language.
The 30-day trend diagrams are based on “runs” of exchange rate movements within a tunnel. This is essentially a heuristic trending technique. The tunnel is constructed to be as long and as narrow as possible. The tradeoff between length and width is determined by a scoring function defined by the trender. The computations are carried out using PROC IML in the SAS language with code developed by the author.
|I make no warranties, express or implied, that the exchange rate trends/forecasts are accurate, useful, consistent with any economic theory, reliable, or consistent with any particular standard of merchantability, or that they will meet your requirements for any particular application. These forecasts should not be relied upon for carrying out any currency transactions which could result in injury to a person or loss of property. If you do use the forecasts in such a manner, it is at your own risk. I disclaim all liability for direct or consequential damages resulting from your use of these forecasts.