Methods of Forecasting Exchange Rates

Organizations engaged in international business transactions must remain cognizant of prevailing exchange rates and the possibility for change within those markets. The challenges inherent in understanding how the value of a currency might move over the course of a production cycle may ultimately determine the success or failure of a business unit. According to Madura (2008), “The numerous methods available for forecasting exchange rates can be categorized into four general groups: technical, fundamental, market based, and mixed” (p. 252).

Technical forecasting, similar to technical analysis of stock price movements, assumes movements will occur in response to trends. Benjamin Graham (1973) was not particularly fond of technical analysis:

"The one principle that applies to nearly all these so-called ‘technical approaches’ is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success on Wall Street.” (p. 2-3)

I believe that the wisdom of Graham can be applied similarly to the question at hand. The idea that what goes up will shortly thereafter come down is not a very scientific approach to analysis.

Fundamental analysis uses complex modeling algorithms to estimate future rates of exchange. According to Madura (2008), “A forecast may arise simply from a subjective assessment of the degree to which general movements in economic variables in one country are expected to affect exchange rates” (p. 254). While modeling may be able to accurately account and discount the multitude of variables, future results may not reflect congruence with previous findings. As such, even the most complex fundamental modeling techniques may result in significant inaccuracies.

Market based forecasting generally assumes that current speculation will reflect the actuality of future conditions. Relying on market indicators, proponents of this method use spot rates or forward rates to determine the movement of currencies. In light of the significant speculation inherent in these market indicators, market based forecasting will not always result in accurate predictions.

Mixed forecasting is the natural result of the lack of a single and superior method of predicting rates of exchange. Essentially, mixed forecasting assigns weighted values to the results derived from other valuation techniques. The success of this method will depend on the subjective interpretations of the organization that apply it. If all indicators seem to lead to the conclusion that a currency will devalue, for example, the likely conclusion is that it is so. By utilizing the combined utility of each method, mixed forecasting stands out as the most useful method for making interpretations on future currency exchange rates. With that said, mixed forecasting exists because of the failure of any of the other methods to present reliable and accurate findings.

So essentially, we utilize the collective and unreliable results of other methods to attempt to derive accurate conclusions. Mixed forecasting, unlike the other techniques, offers no singular theory but rather relies on the results of the others. Weighing these results by assigning a relative value, we speculate on which factors are most important. In the end, currency markets remain speculative in nature. Organizations must remain cognizant of this and hedge their risk against the potential for miscalculation.

References

Graham, B. (1973). The Intelligent Investor – Revised Edition. New York:
HarperCollins Publishers.

Madura, J. (2008). International Financial Management (9th ed.). Ohio: Cengage Learning

Keyword: management cadre, global economy, international business, exchange rates, economic incentive, foreign investment