Exchange Rate Forecasting: Techniques and Applications

Exchange Rate Forecasting: Techniques and Applications

Exchange Rate Forecasting: Techniques and Applications Imad A. Moosa Reader in Economics and Finance La Trobe University MACMILLAN Business

Imad A. Moosa 2000 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P OLP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2000 by MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world ISBN 0-333-73644-3 hardcover A catalogue record for this book is available from the British Library. 10 9 8 7 6 5 4 3 2 1 09 08 07 06 05 04 03 02 01 00 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

To Nisreen and Danny

Contents List of Figures and Tables Currency Symbols Preface xii xvii xviii 1 Expectation and Forecasting: An Overview 1 The Tale of a Young Tourist 1 The Tale of a Business Manager 3 The Importance of Forecasting 4 The Importance of the Exchange Rate 8 Exchange Rate Forecasting: Some Preliminaries 11 Which Exchange Rate? 16 The Expectations Formation Mechanisms 17 Stylised Facts about the Behaviour of Exchange Rates 20 Final Remarks 30 2 Exchange Rate Forecasting as an Input in the Decision-making Process 32 Introduction 32 Spot Speculation 33 Uncovered Interest Arbitrage 37 Spot-forward Speculation 41 Forward Speculation 42 Speculation with Options 43 Hedging Transaction Exposure 46 Measurement and Hedging of Economic Exposure 53 Hedging Translation Exposure 54 Short-term Financing and Investment Decisions 54 Long-term Financing and Investment Decisions 56 Foreign Direct Investment 56 Pricing and Strategic Planning 57 Central Bank Intervention and Macroeconomic Policy 58 Decision Rules Not Requiring Exchange Rate Forecasting 58 Concluding Remarks 60 vii

Contents 3 Univariate Time Series Techniques 62 Introduction 62 The Forecasting Set-up 63 Averaging Methods 64 Smoothing Methods 71 Time Series Decomposition 75 The Box-Jenkins Methodology: ARIMA Modelling 79 Time Series Analysis: Harvey's Structural Time Series Model 89 Computer Software 93 Further Reading 97 4 Multivariate Time Series Models 98 An Overview 98 Single-equation Economic Models: Specification and Forecasting 99 Problems with Single-equation Models 101 Theoretical Foundations: Purchasing Power Parity 103 Theoretical Foundations: Covered and Uncovered Interest Parity 107 Theoretical Foundations: The Flow Model 109 Theoretical Foundations: The Flexible-price Monetary Model 110 Theoretical Foundations: Extensions to the Flexible-price Monetary Model 112 Theoretical Foundations: The Sticky-price Monetary Model 115 Theoretical Foundations: Other Models of Exchange Rates 116 Single-equation Models: Some Econometric Issues 120 Single-equation Structural Time Series Models 128 Multi-equation Economic Models 129 Empirical Evidence 131 Computer Software 133 Further Reading 133 5 Market-based Forecasting: The Spot and Forward Exchange Rates 134 viii Introduction 134 The Spot Rate as a Forecaster: The Random Walk Model 134 Some Modifications 138 The Forward Rate as a Forecaster: The Unbiased Efficiency Hypothesis 139

Contents Empirical Evidence and Rationalisation 141 Other Concepts of Market Efficiency 145 Cross-sectional Efficiency and Cointegration 147 6 Judgemental and Composite Forecasting 150 Judgemental Forecasting: An Overview 150 Judgemental Forecasting as Part of the Decision-making Process 152 Judgemental Manipulation of Forecasts 161 The Role of Judgement in Scenario Writing 163 Judgemental Forecasting: Final Remarks 166 Composite Forecasting: An Overview 167 Methods of Combining Forecasts 168 Consensus Forecasts 172 7 Technical Analysis 173 Definition and Underlying Principles 173 The Dow Theory and the Elliott Wave Theory 175 Types of Charts 180 Chart Formations: Trendlines and Channels 183 Support, Resistance, Retracement and Speed Resistance Lines 190 Reversal Patterns 197 Continuation Patterns 208 Bullish Reversal Patterns in Candlestick Charts 209 Bearish Reversal Patterns in Candlestick Charts 214 Continuation Patterns in Candlestick Charts 218 Quantitative Technical Indicators 221 The Economics of Technical Analysis 226 Computer Software and Further Reading 230 8 Trading Rules 233 Introduction 233 Simple Filter Rules 233 Filter Rules with Bid-Offer Spreads and Interest Rates 246 Moving Average Rules 251 Trading Rules Based on Quantitative Technical Indicators 258 Fundamental Trading Rules 258 Measuring the Profitability of Trading Rules 264 Empirical Evidence on the Profitability of Trading Rules 268 ix

Contents 9 Recent Developments: Chaos and Neural Networks 270 Introduction 270 Chaos Theory: Background 270 Deterministic and Stochastic Models 272 Nonlinear and Chaotic Models 277 A Comparison Between Chaotic and Stochastic Processes 296 Sources of Nonlinearity 297 Implications of Chaos for Forecasting 303 Testing and Empirical Evidence 304 Artificial Neural Networks: An Overview 307 ANN Structure 308 The Functioning of ANNs 311 Applications to Exchange Rates: Methodology and Empirical Evidence 313 Computer Software and Further Reading 315 10 Measuring Forecasting Accuracy 316 Introduction 316 Some General Considerations 316 Testing the Significance of the Difference between Actual and Forecast Values 332 Graphical Techniques for Measuring and Monitoring Forecasting Accuracy 333 Quantitative Measures of Forecasting Accuracy 336 11 Selection, Implementation and Monitoring of Forecasts 348 The Tale of Two Exchange Rate Forecasters 348 Why Do Forecasters Differ? 350 Internal or External Forecasters?. 352 Selecting an External Forecaster 354 Forecast Implementation 358 Monitoring of Forecasts 359 Appendix to Chapter 11: Foreign Exchange Forecasting Services in Practice 361 12 Case Studies 366 Case Study 1: ABC Home Furniture Limited 366 Case Study 2: DEF Office Equipment Limited 369 Case Study 3: GHI Financial Services Limited 374 Case Study 4: JKL Electronics Limited 376 Case Study 5: MNP Trading Company Limited 379

Contents 13 Concluding Remarks 381 Recapitulation 381 Vital Questions 382 Where 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 (daily data, 23 Oct 1995-6 March 1998) 22 1.3 Random numbers 23 1.4 An artificial exchange rate series 23 1.5 A scatter diagram of the change in the effective exchange rate on the inflation rate (pooled data) 25 1.6 The dollar/mark exchange rate and prices (Germany, 1919-1923), logarithmic scale 25 1.7 A scatter diagram of the dollar/mark exchange rate on prices (Germany, 1919-1923), logarithmic scale 26 1.8 A scatter diagram of the change in the effective exchange rate on the current account position (pooled data) 27 1.9 A scatter diagram of the change in the effective exchange rate on the monetary (Ml) growth rate (pooled data) 27 1.10 A scatter diagram of the change in the effective exchange rate on the monetary (M2) growth rate (pooled data) 28 1.11 A scatter diagram of the dollar/mark exchange rate on the money supply (Germany, 1919-1923), logarithmic scale 29 1.12 A scatter diagram of the change in the effective exchange rate on the interest rate (pooled data) 29 3.1 Some possible time series patterns 80 3.2 Patterns of autocorrelation and partial autocorrelation functions 86 5.1 Confidence interval for random walk forecasts 137 5.2 Confidence interval for forecasts from random walk with drift 138 5.3 GBP/USD: spot and lagged three-month forward rate 142 6.1 Decision tree for hedging 154 6.2 Decision tree for short-term financing (1) 156 6.3 Decision tree for short-term financing (2) 159 7.1 Time path generated by shifting supply and demand curves 175 7.2 Bull and bear markets in the Dow theory 177 7.3 The Elliott wave theory 178 7.4 Elliott waves in bull and bear markets 179 xii

List of Figures and Tables 7.5 Bar charts 181 7.6 A point and figure chart 183 7.7 Japanese candlestick chart 184 7.8 Candlestick lines 185 7.9 Trends 186 7.10 Trendline penetration 188 7.11 Trend channels 189 7.12 The fan 191 7.13 Support and resistance levels 192 7.14 Changing support and resistance levels 193 7.15 Role reversal of support and resistance levels 195 7.16 Trend reversal 196 7.17 Percentage retracements 198 7.18 Speed resistance lines 199 7.19 Reversal patterns 200 7.20 Continuation patterns 210 7.21 Bullish reversal patterns in candlestick charts 212 7.22 Bearish reversal patterns in candlestick charts 216 7.23 Continuation patterns in candlestick charts 219 7.24 Buy and sell signals generated by the RSI 225 7.25 Bearish and bullish divergence as indicated by the stochastics 227 7.26 USD/AUD daily bar chart 230 7.27 DEM/USD daily bar chart 230 7.28 USD/GBP daily bar chart 231 7.29 JPY/USD daily bar chart 231 7.30 JPY/USD monthly candlestick chart 231 8.1 x per cent filter rule 234 8.2 The effect of the filter size 237 8.3 Profitable and unprofitable filter sizes (1) 238 8.4 Profitable and unprofitable filter sizes (2) 240 8.5 Filter rules in bull and bear markets 243 8.6 The analytics of filter rules 244 8.7 Profitable and unprofitable time paths 245 8.8 The single moving average rule 253 8.9 The GBP/USD exchange rate (daily observations ending 6 March 1998) 255 8.10 Difference between the GBP/USD exchange rate and the 10-day moving average 256 8.11 10-day and 20-day moving averages of the GBP/USD exchange rate 257 8.12 Difference between the 10-day and 20-day moving averages 257 8.13 Trading rules based on quantitative technical indicators 259 8.14 An x per cent fundamental rule 261 xiii

List of Figures and Tables 8.15 An x per cent fundamental rule based on the deviation of the actual rate from the equilibrium rate 262 8.16 Comparing an x per cent fundamental rule with a y per cent technical rule (constant equilibrium rate) 265 9.1 The behaviour of the exchange rate as generated by a deterministic model 273 9.2 The behaviour of the exchange rate as generated by a stochastic model 276 9.3 Decomposition of the exchange rate series into deterministic and stochastic components 278 9.4 The behaviour of the exchange rate as generated by a nonlinear logistic function (initial value = 0.50) 281 9.5 The behaviour of the exchange rate as generated by a nonlinear logistic function (initial value = 0.25) 287 9.6 Sensitivity of the behaviour of the exchange rate to the initial value and the tuning parameter 294 9.7 Non-chaotic, nonlinear behaviour of the exchange rate 296 9.8 The behaviour of chaotic and stochastic processes 298 9.9 Phase portraits of chaotic and stochastic processes 299 9.10 The behaviour of the exchange rate as generated by a linear deterministic model 300 9.11 Sensitivity of the behaviour of the exchange rate as generated by a linear deterministic model 301 9.12 The working of an artificial neuron (unit) 309 9.13 A feedforward ANN 310 9.14 The sigmoid (logistic) transfer function 312 9.15 The training process in ANNs 313 10.1 Dynamic forecasting error of a random walk model 323 10.2 Static forecasting error of a random walk model 324 10.3 Forecasting error of an ARMA (1, 2) model 325 10.4 A control chart 334 10.5 The prediction-realisation diagram 335 10.6 The prediction-realisation diagrams for models with different forecasting accuracy 337 10.7 The prediction-realisation diagram for uncovered interest parity 339 10.8 The modified prediction-realisation diagram 340 12.1 Quarterly exchange rates (1974-1993) 371 TABLES 1.1 Some problems requiring exchange rate forecasting 5 2.1 Conditions for profitable uncovered arbitrage 39 xiv

List of Figures and Tables 2.2 Decision rules for money market hedging 48 2.3 Decision rules for forward market hedging 49 2.4 Call option hedging with a probability distribution 50 2.5 Put option hedging with a probability distribution 51 2.6 Decision rules for the choice of a hedge 52 3.1 The forecasting set-up 64 3.2 A time framework for the calculation of single and double moving averages 69 3.3 Actual and forecast exchange rates based on moving averages at 2k 1 70 3.4 Some special ARIMA models 84 3.5 Behaviour of autocorrelation and partial autocorrelation functions for some ARIMA models 85 6.1 The effective financing rate under two scenarios 155 6.2 Expected values of effective financing rate 157 6.3 Interest and exchange rates 158 6.4 Exchange rates and effective financing rates 159 6.5 Expected values and standard deviations of effective rates of return 160 6.6 Effective financing rates and associated probabilities 161 6.7 Scenarios for a PPP model 166 8.1 Breakeven filter sizes corresponding to 9 (per cent) 246 8.2 Breakeven filter sizes corresponding to 9 and m 248 8.3 Breakeven filter sizes corresponding to 9, i, i* and n + k j 250 10.1 Static and dynamic forecasts 321 10.2 Static and dynamic forecasts of the random walk model 322 10.3 Bias and accuracy of forecasts 326 10.4 Forecasting errors as a percentage of the actual values 327 10.5 Different forecasting horizons 328 10.6 Forecasting horizons and weights 329 10.7 Implications of the value of Theil's inequality coefficient 343 11.1 Possibilities for forecast values 353 12.1 Value of timber in foreign currency terms 367 12.2 Expected price levels 368 12.3 The forecast exchange rates and pound values of imported timber 369 12.4 Coupon rates and exchange rates at the end of 1993 370 12.5 Principal, interest payment and total repayment in various currencies 370 12.6 Forecast exchange rates (1994-98) 373 12.7 Forecast interest payments and total repayments (USD) 374 12.8 Daily exchange rate forecasts 375 12.9 Actual values of the exchange rate 376 12.10 Measures of forecasting accuracy 377 xv

List of Figures and Tables 12.11 The four scenarios 378 12.12 Exchange rates and dollar cash flows under the four scenarios 378 12.13 The forecasting models 380 12.14 Forecasts generated by various models 380 13.1 Some decision rules requiring exchange rate forecasting 384 xvi

Currency Symbols The following are the three-letter symbols of the currencies used in this book: AUD CAD CHF FRF GBP JPY NOK USD Australian dollar Canadian dollar Swiss franc French franc British pound Japanese yen Norwegian krone US dollar XVII

Preface Writing a book on exchange rate forecasting is not an easy task. There are at least two related problems concerning the subject matter and the targeted readership. The problem with the subject matter is that a book on exchange rate forecasting may concentrate on the techniques of forecasting, and in the extreme 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 of forecasting. This book encompasses both aspects of the subject matter, a feature that proved to be problematical, particularly in the presence of strict manuscript length constraints. I have, therefore, endeavoured to strike a balance between the two aspects at the cost of making the treatment of some topics look rather superficial. I must, for this reason, make it clear at the outset that this is not a textbook on econometrics. The basics of the econometric methods used to forecast exchange rates are explained within the constraints implied by the manuscript length and the objective of striking a balance between the two features mentioned above. In order to remedy this deficiency I have, whenever necessary, included a section referring the reader to other references that elaborate on the subject matter. The second problem pertains to the choice of readership. Three classes of readers can be targeted by a book on exchange rate forecasting. The first are the well-established forecasters who are acquainted with the methods of forecasting. The second are the young forecasters who are developing their skills to become fully fledged forecasters. The third are not the forecasters, but rather the users of forecasts, the managers who take the decisions using forecasts as an input in the decision-making process. All of these classes are targeted to different extents. While readers belonging to the first class can overlook the material on the forecasting methods, they can benefit from the description of how their forecasts are used by the actual decision makers. Some of these forecasters can also benefit from the material on technical analysis and trading rules. For the forecasters who primarily use technical analysis, on the other hand, the book provides a broad survey of the econometric methods of forecasting and the economic models that explain, or attempt to explain, the behaviour of exchange rates. The second class of would-be readers are those forecasters who are not so experienced. The book provides a very accessible survey of what they should learn if they xviii