Exchange Rate Forecasting:Techniques and Applications

Exchange RateForecasting: Techniques

and Applications

Imad A. MoosaReader in Economics and Finance

La Trobe University

MACMILLANBusiness

© Imad A. Moosa 2000

All rights reserved. No reproduction, copy or transmission ofthis publication may be made without written permission.

No paragraph of this publication may be reproduced, copied ortransmitted save with written permission or in accordance withthe provisions of the Copyright, Designs and Patents Act 1988,or under the terms of any licence permitting limited copyingissued by the Copyright Licensing Agency, 90 Tottenham CourtRoad, London W1P OLP.

Any person who does any unauthorised act in relation to thispublication may be liable to criminal prosecution and civilclaims for damages.

The author has asserted his right to be identified as theauthor of this work in accordance with the Copyright,Designs and Patents Act 1988.

First published 2000 byMACMILLAN PRESS LTDHoundmills, Basingstoke, Hampshire RG21 6XSand LondonCompanies and representativesthroughout the world

ISBN 0-333-73644-3 hardcover

A catalogue record for this book is availablefrom the British Library.

10 9 8 7 6 5 4 3 2 109 08 07 06 05 04 03 02 01 00

Printed and bound in Great Britainby Antony Rowe Ltd, Chippenham, Wiltshire

To Nisreen and Danny

Contents

List of Figures and Tables xii

Currency Symbols xvii

Preface xviii

1 Expectation and Forecasting: An Overview 1

The Tale of a Young Tourist 1The Tale of a Business Manager 3The Importance of Forecasting 4The Importance of the Exchange Rate 8Exchange Rate Forecasting: Some Preliminaries 11Which Exchange Rate? 16The Expectations Formation Mechanisms 17Stylised Facts about the Behaviour of Exchange Rates 20Final Remarks 30

2 Exchange Rate Forecasting as an Input in theDecision-making Process 32

Introduction 32Spot Speculation 33Uncovered Interest Arbitrage 37Spot-forward Speculation 41Forward Speculation 42Speculation with Options 43Hedging Transaction Exposure 46Measurement and Hedging of Economic Exposure 53Hedging Translation Exposure 54Short-term Financing and Investment Decisions 54Long-term Financing and Investment Decisions 56Foreign Direct Investment 56Pricing and Strategic Planning 57Central Bank Intervention and Macroeconomic Policy 58Decision Rules Not Requiring Exchange Rate Forecasting 58Concluding Remarks 60

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Contents

3 Univariate Time Series Techniques 62

Introduction 62The Forecasting Set-up 63Averaging Methods 64Smoothing Methods 71Time Series Decomposition 75The Box-Jenkins Methodology: ARIMA Modelling 79Time Series Analysis: Harvey's Structural Time Series Model 89Computer Software 93Further Reading 97

4 Multivariate Time Series Models 98

An Overview 98Single-equation Economic Models: Specification and

Forecasting 99Problems with Single-equation Models 101Theoretical Foundations: Purchasing Power Parity 103Theoretical Foundations: Covered and Uncovered Interest

Parity 107Theoretical Foundations: The Flow Model 109Theoretical Foundations: The Flexible-price Monetary Model 110Theoretical Foundations: Extensions to the Flexible-price

Monetary Model 112Theoretical Foundations: The Sticky-price Monetary Model 115Theoretical Foundations: Other Models of Exchange Rates 116Single-equation Models: Some Econometric Issues 120Single-equation Structural Time Series Models 128Multi-equation Economic Models 129Empirical Evidence 131Computer Software 133Further Reading 133

5 Market-based Forecasting: The Spot and ForwardExchange Rates 134

Introduction 134The Spot Rate as a Forecaster: The Random Walk Model 134Some Modifications 138The Forward Rate as a Forecaster: The Unbiased

Efficiency Hypothesis 139

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Contents

Empirical Evidence and Rationalisation 141Other Concepts of Market Efficiency 145Cross-sectional Efficiency and Cointegration 147

6 Judgemental and Composite Forecasting 150

Judgemental Forecasting: An Overview 150Judgemental Forecasting as Part of the Decision-making

Process 152Judgemental Manipulation of Forecasts 161The Role of Judgement in Scenario Writing 163Judgemental Forecasting: Final Remarks 166Composite Forecasting: An Overview 167Methods of Combining Forecasts 168Consensus Forecasts 172

7 Technical Analysis 173

Definition and Underlying Principles 173The Dow Theory and the Elliott Wave Theory 175Types of Charts 180Chart Formations: Trendlines and Channels 183Support, Resistance, Retracement and Speed

Resistance Lines 190Reversal Patterns 197Continuation Patterns 208Bullish Reversal Patterns in Candlestick Charts 209Bearish Reversal Patterns in Candlestick Charts 214Continuation Patterns in Candlestick Charts 218Quantitative Technical Indicators 221The Economics of Technical Analysis 226Computer Software and Further Reading 230

8 Trading Rules 233

Introduction 233Simple Filter Rules 233Filter Rules with Bid-Offer Spreads and Interest Rates 246Moving Average Rules 251Trading Rules Based on Quantitative Technical Indicators 258Fundamental Trading Rules 258Measuring the Profitability of Trading Rules 264Empirical Evidence on the Profitability of Trading Rules 268

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Contents

9 Recent Developments: Chaos and Neural Networks 270

Introduction 270Chaos Theory: Background 270Deterministic and Stochastic Models 272Nonlinear and Chaotic Models 277A Comparison Between Chaotic and Stochastic Processes 296Sources of Nonlinearity 297Implications of Chaos for Forecasting 303Testing and Empirical Evidence 304Artificial Neural Networks: An Overview 307ANN Structure 308The Functioning of ANNs 311Applications to Exchange Rates: Methodology and Empirical

Evidence 313Computer Software and Further Reading 315

10 Measuring Forecasting Accuracy 316

Introduction 316Some General Considerations 316Testing the Significance of the Difference between Actual and

Forecast Values 332Graphical Techniques for Measuring and Monitoring

Forecasting Accuracy 333Quantitative Measures of Forecasting Accuracy 336

11 Selection, Implementation and Monitoring of Forecasts 348

The Tale of Two Exchange Rate Forecasters 348Why Do Forecasters Differ? 350Internal or External Forecasters? . 352Selecting an External Forecaster 354Forecast Implementation 358Monitoring of Forecasts 359Appendix to Chapter 11: Foreign Exchange Forecasting

Services in Practice 361

12 Case Studies 366

Case Study 1: ABC Home Furniture Limited 366Case Study 2: DEF Office Equipment Limited 369Case Study 3: GHI Financial Services Limited 374Case Study 4: JKL Electronics Limited 376Case Study 5: MNP Trading Company Limited 379

Contents

13 Concluding Remarks 381

Recapitulation 381Vital Questions 382Where Do We Go from Here? 387

Glossary 390

References 409

Index 419

XI

List of Figures and Tables

FIGURES

1.1 The GBP/USD exchange rate (daily data, 23 Oct 1995-6 March 1998) 22

1.2 Percentage change in the GBP/USD exchange rate (dailydata, 23 Oct 1995-6 March 1998) 22

1.3 Random numbers 231.4 An artificial exchange rate series 231.5 A scatter diagram of the change in the effective exchange

rate on the inflation rate (pooled data) 251.6 The dollar/mark exchange rate and prices (Germany,

1919-1923), logarithmic scale 251.7 A scatter diagram of the dollar/mark exchange rate on

prices (Germany, 1919-1923), logarithmic scale 261.8 A scatter diagram of the change in the effective exchange

rate on the current account position (pooled data) 271.9 A scatter diagram of the change in the effective exchange

rate on the monetary (Ml) growth rate (pooled data) 271.10 A scatter diagram of the change in the effective exchange

rate on the monetary (M2) growth rate (pooled data) 281.11 A scatter diagram of the dollar/mark exchange rate on the

money supply (Germany, 1919-1923), logarithmic scale 291.12 A scatter diagram of the change in the effective exchange

rate on the interest rate (pooled data) 293.1 Some possible time series patterns 803.2 Patterns of autocorrelation and partial autocorrelation

functions 865.1 Confidence interval for random walk forecasts 1375.2 Confidence interval for forecasts from random walk with

drift 1385.3 GBP/USD: spot and lagged three-month forward rate 1426.1 Decision tree for hedging 1546.2 Decision tree for short-term financing (1) 1566.3 Decision tree for short-term financing (2) 1597.1 Time path generated by shifting supply and demand curves 1757.2 Bull and bear markets in the Dow theory 1777.3 The Elliott wave theory 1787.4 Elliott waves in bull and bear markets 179

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List of Figures and Tables

7.5 Bar charts 1817.6 A point and figure chart 1837.7 Japanese candlestick chart 1847.8 Candlestick lines 1857.9 Trends 1867.10 Trendline penetration 1887.11 Trend channels 1897.12 The fan 1917.13 Support and resistance levels 1927.14 Changing support and resistance levels 1937.15 Role reversal of support and resistance levels 1957.16 Trend reversal 1967.17 Percentage retracements 1987.18 Speed resistance lines 1997.19 Reversal patterns 2007.20 Continuation patterns 2107.21 Bullish reversal patterns in candlestick charts 2127.22 Bearish reversal patterns in candlestick charts 2167.23 Continuation patterns in candlestick charts 2197.24 Buy and sell signals generated by the RSI 2257.25 Bearish and bullish divergence as indicated by the

stochastics 2277.26 USD/AUD daily bar chart 2307.27 DEM/USD daily bar chart 2307.28 USD/GBP daily bar chart 2317.29 JPY/USD daily bar chart 2317.30 JPY/USD monthly candlestick chart 2318.1 x per cent filter rule 2348.2 The effect of the filter size 2378.3 Profitable and unprofitable filter sizes (1) 2388.4 Profitable and unprofitable filter sizes (2) 2408.5 Filter rules in bull and bear markets 2438.6 The analytics of filter rules 2448.7 Profitable and unprofitable time paths 2458.8 The single moving average rule 2538.9 The GBP/USD exchange rate (daily observations ending

6 March 1998) 2558.10 Difference between the GBP/USD exchange rate and the

10-day moving average 2568.11 10-day and 20-day moving averages of the GBP/USD

exchange rate 2578.12 Difference between the 10-day and 20-day moving averages 2578.13 Trading rules based on quantitative technical indicators 2598.14 An x per cent fundamental rule 261

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List of Figures and Tables

8.15 An x per cent fundamental rule based on the deviation of theactual rate from the equilibrium rate 262

8.16 Comparing an x per cent fundamental rule with a y per centtechnical rule (constant equilibrium rate) 265

9.1 The behaviour of the exchange rate as generated by adeterministic model 273

9.2 The behaviour of the exchange rate as generated by astochastic model 276

9.3 Decomposition of the exchange rate series intodeterministic and stochastic components 278

9.4 The behaviour of the exchange rate as generated by anonlinear logistic function (initial value = 0.50) 281

9.5 The behaviour of the exchange rate as generated by anonlinear logistic function (initial value = 0.25) 287

9.6 Sensitivity of the behaviour of the exchange rate to theinitial value and the tuning parameter 294

9.7 Non-chaotic, nonlinear behaviour of the exchange rate 2969.8 The behaviour of chaotic and stochastic processes 2989.9 Phase portraits of chaotic and stochastic processes 2999.10 The behaviour of the exchange rate as generated by a linear

deterministic model 3009.11 Sensitivity of the behaviour of the exchange rate as

generated by a linear deterministic model 3019.12 The working of an artificial neuron (unit) 3099.13 A feedforward ANN 3109.14 The sigmoid (logistic) transfer function 3129.15 The training process in ANNs 313

10.1 Dynamic forecasting error of a random walk model 32310.2 Static forecasting error of a random walk model 32410.3 Forecasting error of an ARMA (1, 2) model 32510.4 A control chart 33410.5 The prediction-realisation diagram 33510.6 The prediction-realisation diagrams for models with

different forecasting accuracy 33710.7 The prediction-realisation diagram for uncovered interest

parity 33910.8 The modified prediction-realisation diagram 34012.1 Quarterly exchange rates (1974-1993) 371

TABLES

1.1 Some problems requiring exchange rate forecasting 52.1 Conditions for profitable uncovered arbitrage 39

xiv

List of Figures and Tables

2.2 Decision rules for money market hedging 482.3 Decision rules for forward market hedging 492.4 Call option hedging with a probability distribution 502.5 Put option hedging with a probability distribution 512.6 Decision rules for the choice of a hedge 523.1 The forecasting set-up 643.2 A time framework for the calculation of single and double

moving averages 693.3 Actual and forecast exchange rates based on moving

averages at 2k — 1 703.4 Some special ARIMA models 843.5 Behaviour of autocorrelation and partial autocorrelation

functions for some ARIMA models 856.1 The effective financing rate under two scenarios 1556.2 Expected values of effective financing rate 1576.3 Interest and exchange rates 1586.4 Exchange rates and effective financing rates 1596.5 Expected values and standard deviations of effective rates

of return 1606.6 Effective financing rates and associated probabilities 1616.7 Scenarios for a PPP model 1668.1 Breakeven filter sizes corresponding to 9 (per cent) 2468.2 Breakeven filter sizes corresponding to 9 and m 2488.3 Breakeven filter sizes corresponding to 9, i, i* and n + k —j 250

10.1 Static and dynamic forecasts 32110.2 Static and dynamic forecasts of the random walk model 32210.3 Bias and accuracy of forecasts 32610.4 Forecasting errors as a percentage of the actual values 32710.5 Different forecasting horizons 32810.6 Forecasting horizons and weights 32910.7 Implications of the value of Theil's inequality coefficient 34311.1 Possibilities for forecast values 35312.1 Value of timber in foreign currency terms 36712.2 Expected price levels 36812.3 The forecast exchange rates and pound values of imported

timber 36912.4 Coupon rates and exchange rates at the end of 1993 37012.5 Principal, interest payment and total repayment in various

currencies 37012.6 Forecast exchange rates (1994-98) 37312.7 Forecast interest payments and total repayments (USD) 37412.8 Daily exchange rate forecasts 37512.9 Actual values of the exchange rate 37612.10 Measures of forecasting accuracy 377

xv

List of Figures and Tables

12.11 The four scenarios 37812.12 Exchange rates and dollar cash flows under the four

scenarios 37812.13 The forecasting models 38012.14 Forecasts generated by various models 38013.1 Some decision rules requiring exchange rate forecasting 384

xv i

Currency Symbols

The following are the three-letter symbols of the currencies used in thisbook:

AUDCADCHFFRFGBPJPYNOKUSD

Australian dollarCanadian dollarSwiss francFrench francBritish poundJapanese yenNorwegian kroneUS dollar

XVII

Preface

Writing a book on exchange rate forecasting is not an easy task. There are atleast two related problems concerning the subject matter and the targetedreadership. The problem with the subject matter is that a book on exchangerate forecasting may concentrate on the techniques of forecasting, and in theextreme case it becomes a book on econometrics. It may, on the other hand,emphasise the applications and use of forecasts in business decision making,in which case less emphasis is placed on the econometrics and statistics offorecasting. This book encompasses both aspects of the subject matter, afeature that proved to be problematical, particularly in the presence of strictmanuscript length constraints. I have, therefore, endeavoured to strike abalance between the two aspects at the cost of making the treatment of sometopics look rather superficial. I must, for this reason, make it clear at theoutset that this is not a textbook on econometrics. The basics of theeconometric methods used to forecast exchange rates are explained withinthe constraints implied by the manuscript length and the objective ofstriking a balance between the two features mentioned above. In order toremedy this deficiency I have, whenever necessary, included a sectionreferring the reader to other references that elaborate on the subject matter.

The second problem pertains to the choice of readership. Three classes ofreaders can be targeted by a book on exchange rate forecasting. The first arethe well-established forecasters who are acquainted with the methods offorecasting. The second are the young forecasters who are developing theirskills to become fully fledged forecasters. The third are not the forecasters,but rather the users of forecasts, the managers who take the decisions usingforecasts as an input in the decision-making process. All of these classes aretargeted to different extents. While readers belonging to the first class canoverlook the material on the forecasting methods, they can benefit from thedescription of how their forecasts are used by the actual decision makers.Some of these forecasters can also benefit from the material on technicalanalysis and trading rules. For the forecasters who primarily use technicalanalysis, on the other hand, the book provides a broad survey of theeconometric methods of forecasting and the economic models that explain,or attempt to explain, the behaviour of exchange rates. The second class ofwould-be readers are those forecasters who are not so experienced. Thebook provides a very accessible survey of what they should learn if they

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