Chapter 9 Outline

Exchange Rate Forecasting

A company's need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid decision making. Two schools of thought address this issue. The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money. The other school of thought, the inefficient market school, argues that companies can improve the foreign exchange market's estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services. In other words, this school of thought does not believe the forward exchange rates are the best possible predictors of future spot exchange rates.

The Efficient Market School

Forward exchange rates represent market participants' collective predictions of likely spot exchange rates at specified future dates. If forward exchange rates are the best possible predictor of future spot rates, it would make no sense for companies to spend additional money trying to forecast short-run exchange rate movements. Many economists believe the foreign exchange market is efficient at setting forward rates.¹⁴ An efficient market is one in which prices reflect all available public information. (If forward rates reflect all available information about likely future changes in exchange rates, there is no way a company can beat the market by investing in forecasting services.)

If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates. This does not mean the predictions will be accurate in any specific situation. It means inaccuracies will not be consistently above or below future spot rates; they will be random. Many empirical tests have addressed the efficient market hypothesis. Although most of the early work seems to confirm the hypothesis (suggesting that companies should not waste their money on forecasting services), more recent studies have challenged it.¹⁵ There is some evidence that forward rates are not unbiased predictors of future spot rates, and that more accurate predictions of future spot rates can be calculated from publicly available information.¹⁶

The Inefficient Market School

Citing evidence against the efficient market hypothesis, some economists believe the foreign exchange market is inefficient. An inefficient market is one in which prices do not reflect all available information. In an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates.

If this is true, it may be worthwhile for international businesses to invest in forecasting services (as many do). The belief is that professional exchange rate forecasts might provide better predictions of future spot rates than forward exchange rates do. It should be pointed out, however, that the track record of professional forecasting services is not that good. An analysis of the forecasts of 12 major forecasting services between 1978 and 1982 concluded the forecasters in general did not provide better forecasts than the forward exchange rates.¹⁷ Also, forecasting services did not predict the 1997 currency crisis that swept through Southeast Asia.

Approaches to Forecasting

Assuming the inefficient market school is correct that the foreign exchange market's estimate of future spot rates can be improved, on what basis should forecasts be prepared? Here again, there are two schools of thought. One adheres to fundamental analysis, while the other uses technical analysis. Fundamental Analysis

Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. The variables contained in these models typically include those we have discussed, such as relative money supply growth rates, inflation rates, and interest rates. In addition, they may include variables related to balance-of-payments positions.

Running a deficit on a balance-of-payments current account (a country is importing more goods and services than it is exporting), creates pressures that result in the depreciation of the country's currency on the foreign exchange market.¹⁸ (For background on the balance of payments, see Chapter 7.) Consider what might happen if the United States was running a persistent current account balance-of-payments deficit. Since the United States would be importing more than it was exporting, people in other countries would be increasing their holdings of US dollars. If these people were willing to hold their dollars, the dollar's exchange rate would not be influenced. However, if these people converted their dollars into other currencies, the supply of dollars in the foreign exchange market would increase (as would demand for the other currencies). This shift in demand and supply would create pressures that could lead to the depreciation of the dollar against other currencies.

This argument hinges on whether people in other countries are willing to hold dollars. This depends on such factors as US interest rates and inflation rates. So, in a sense, the balance-of-payments position is not a fundamental predictor of future exchange rate movements. For example, between 1981 and 1985, the US dollar appreciated against most major currencies despite a growing balance-of-payments deficit. Relatively high real interest rates in the United States made the dollar very attractive to foreigners, so they did not convert their dollars into other currencies. Given this, we are back to the argument that the fundamental determinants of exchange rates are monetary growth, inflation rates, and interest rates.

Technical Analysis

Technical analysis uses price and volume data to determine past trends, which are expected to continue into the future. This approach does not rely on a consideration of economic fundamentals. Technical analysis is based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves. Since there is no theoretical rationale for this assumption of predictability, many economists compare technical analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in recent years.¹⁹