Forecasting Future Exchange Rates - Financial Management

The equilibrium relationships discussed in the previous sections can be very useful to managers who need forecasts of future spot exchange rates. Although empirical evidence indicates that these relationships are not perfect, the financial markets in developed countries operate in a way that efficiently incorporates the effect of interest rate differentials in the forward market and the future spot exchange market. Therefore, managers can use the information contained in forward rates and interest rates to make forecasts of the future spot exchange rates. These forecasts are useful, for example, when pricing products for sale in international markets, when making international capital investment decisions, and when deciding whether to hedge foreign currency risks.

Using Forward Rates

The simplest forecast of future spot exchange rates can be derived from current forward rates. If the 1-year forward rate of exchange between dollars and yen is 110 yen/dollar, then this can be used as an unbiased estimate of the expected 1-year future spot rate of exchange between dollars and yen. For example, if Boeing were negotiating the sale of a Boeing 737 airliner to Japan Air with delivery and payment to take place in one year, and if Japan Air insisted on a price quoted in yen, then Boeing could use this forward rate to convert its desired dollar proceeds from the transaction into yen. As we will see in a later section, Boeing may want to hedge against the risk of a change in this exchange rate between the time the contract is signed and the time the plane is delivered and payment is received.

Using Interest Rates

Forward rates provide a direct and convenient forecast of future spot currency exchange rates. Unfortunately, forward quotes normally are not readily available beyond one year. Hence, if a manager needs a longer-term currency exchange rate forecast, forward rates are of little help. Fortunately, one can use observed interest rate differentials between two countries and the general international Fisher effect (IFE) relationship to make longer-term exchange rate forecasts. Recall from that the IFE relationship is given as

Using Interest Rates

This relationship can be modified to cover more than one period into the future as follows:

Using Interest Rates

For example, assume that the annual nominal interest rate on 5-year U.S. Treasury bonds is 6 percent and the annual nominal interest rate on 5-year Swiss government bonds is 4.5 percent. Also, assume that the current spot exchange rate between dollars and Swiss francs (CHF) is $0.6955/CHF.What is the expected future spot rate in five years? It can be calculated using as follows:

S5/$0.6955 = (1 + 0.06)5/(1 + 0.045)5S5 = $0.7469

The IFE relationship predicts that the dollar will lose value relative to the CHF. The expected spot exchange rate in five years is $0.7469/CHF. One could also use the PPP relationship to forecast future exchange rates. However, the advantage of the IFE relationship is that interest rates between two countries are readily observable for almost any maturity, whereas differential levels of future inflation are not. In order to use PPP to make exchange rate forecasts, one would first have to forecast the inflation rates in both countries. Hence it is normally desirable to use the IFE relationship when making longer-term exchange rate forecasts, such as might be needed when evaluating foreign long-term investment projects with cash flows extending several years into the future.

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