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Chapter 8
Exchange Rate Forecasting,
Technical Analysis and Trading Rules
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Objectives
To explain why exchange rate forecasting is neededTo illustrate forecasting techniquesTo explain how to evaluate the performance of forecasters8-*
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Objectives (cont.)
To demonstrate how technical analysis is used to generate buy and sell signalsTo explain how filter rules and moving average rules work8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Definition
Forecasting is a formal process of generating expectationExpectations are implicit forecasts8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Why do we need exchange rate forecasting?
Spot speculation Uncovered interest arbitrage Spot-forward speculationOption speculationHedgingInvestment and capital budgeting8-*
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Why do we need exchange rate forecasting? (cont.)
Financing decisions Pricing decisions Strategic planning Macroeconomic conditionsCentral bank intervention8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Econometric forecasting models
These are models that are specified on the basis of economic theory and estimated by an econometric methodThey are classified into single-equation and multi-equation models8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Single-equation models
The exchange rate (or its rate of change) depends on one or more variables:8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Examples of single-equation models
8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Problems of single-equation models
The black box problemForecasting the explanatory variablesData frequencyStructural changesMeasurement errorsQualitative variables8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Multi-equation models
The black box problem can be solved by specifying a multi-equation model8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Time series models
These are based entirely on the history of the exchange rate:8-*
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Time series models (cont.)
Exchange rates move predominantly in cycles with significant random variation8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Cycles of the US dollars effective exchange rate
8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Problem with time series models
If the FX market is weakly efficient, the exchange rate must follow a random walk. Hence, it is not possible to forecast the exchange rate based on its history8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Market-based forecasting
Using the current market spot and forward rates as forecasters for the future spot rateThis means that market-based forecasts are free and readily available8-*
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Market-based forecasting (cont.)
The reliability of market-based forecasts depends on the validity of the random walk hypothesis and the unbiased efficiency hypothesis8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Spot and lagged forward exchange rates (USD/AUD)
8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
The forward rate forecasting error as a percentage of the spot rate
8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Judgmental forecasting
Judgmental forecasting takes into account all factors affecting exchange ratesIt is not based on a formula derived from a formal model8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Composite forecasting
Composite forecasting is based on two or more forecasts that are derived independentlyForecasting accuracy can be increased by pooling different forecasts8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Combining forecasts
8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Why composite forecasting?
Different forecasters have different degrees of forecasting accuracyDiversification reduces the risk of large forecasting errors8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Forecasting performance evaluation
Performance out of sample is more meaningfulThe loss function is important8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Measures of forecasting accuracy
Mean absolute error (MAE)Mean square error (MSE)Root mean square error (RMSE)8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Magnitude versus direction
Sometimes it is more important to predict the direction rather than the magnitude of the changeThe prediction-realisation diagram can be used to represent magnitude and direction errors8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
The prediction-realisation diagram
8-*
G
C
F
D
E
B
A
H
Line of perfect forecast
Forecast change
Actual change
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
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Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Technical analysis
Technical analysis comprises a variety of practices and procedures used to forecast exchange ratesIt ignores the role of fundamentals8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Rationale for technical analysis
Exchange rates are determined by supply and demandSupply and demand are governed by rational and irrational factorsChanges in trend are caused by shifts in supply and demandHistory repeats itself8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Kinds of charts
Line chartsBar chartsPoint and figure charts8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
A bar chart
8-*
Closing
High
Low
S
Time
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Chart formations
Chartists study charts of exchange rate movements to identify certain patterns8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Trendlines and trading ranges
Trendlines connect ascending bottoms and descending topsThe market is in a trading range when the tops and bottoms are at the same level8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Trendlines and trend channels
8-*
(cont.)
S
Time
(a) Upward trend (bull market)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Trendlines and trend channels (cont.)
8-*
(cont.)
S
Time
(b) Downward trend (bear market)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Trendlines and trend channels (cont.)
8-*
S
Time
(c) Sideways trend (trading range)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
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Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Support and resistance levels
A support level is the bottom of a market swingA resistance level is a point where the market peaks and the exchange rate reverses an upward move8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Creation of resistance and support levels
8-*
Time
S
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Flags
A flag is a continuation patternA flag occurs when a major trend is interrupted8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Triangles
An ascending triangle appears when buyers come to the market at progressively higher levels. Otherwise it will be a descending triangleA symmetrical triangle is difficult to interpret8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Head and shoulders
This formation indicates the reversal of an upward trendA reverse head and shoulders formation implies the opposite8-*
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Head and shoulders (cont.)
8-*
Head
Neckline
Shoulder
Shoulder
Time
S
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Reverse head and shoulders
8-*
Head
Neckline
Shoulder
Shoulder
Time
S
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Market efficiency and trading rules
Market efficiency implies that it is not possible to make profit by adopting a mechanical trading rule or by following buy-sell signals extracted from charts8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Filter rules
An x% filter rule means that a currency is bought when it appreciates by x% from the most recent trough and is sold when it depreciates by x% from the most recent peak8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
A single moving average rule
A single moving average rule means that a currency is bought when the moving average cuts the exchange rate series from above and is sold otherwise8-*
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
-
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
A single moving average rule (cont.)
8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Chart111223344556677889910101111121213131414Exchange rateMoving averageSM1.81.89071.84231.74951.8206251.64451.781751.68581.7305251.77011.7124751.86791.7420751.81981.78591.7611.80471.82581.8186251.92021.83171.84111.8370251.73591.83075Sheet1Figure 12.13SM11.821.890731.842341.74951.82062551.64451.7817561.68581.73052571.77011.71247581.86791.74207591.81981.7859101.7611.8047111.82581.818625121.92021.8317131.84111.837025141.73591.83075Figure 12.14: A Single Moving Average RuleSheet10000000000000000000000000000Exchange RateMoving AverageSM0000000000000000000000000000Sheet2Sheet3 -
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
Double moving average rule
A double moving average rule says that a buy signal is indicated when the long moving average crosses the short moving average from above, and vice versa8-*
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa
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Moving average