Chapter_8

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. Moosa

Slides prepared by Afaf Moosa

Objectives
To explain why exchange rate forecasting is neededTo illustrate forecasting techniquesTo explain how to evaluate the performance of forecasters
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(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



Objectives (cont.)
To demonstrate how technical analysis is used to generate buy and sell signalsTo explain how filter rules and moving average rules work
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Definition
Forecasting is a formal process of generating expectationExpectations are implicit forecasts
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Why do we need exchange rate forecasting?
Spot speculation Uncovered interest arbitrage Spot-forward speculationOption speculationHedgingInvestment and capital budgeting
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(cont.)




Why do we need exchange rate forecasting? (cont.)
Financing decisions Pricing decisions Strategic planning Macroeconomic conditionsCentral bank intervention
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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 models
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Single-equation models
The exchange rate (or its rate of change) depends on one or more variables:
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Examples of single-equation models

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Problems of single-equation models
The black box problemForecasting the explanatory variablesData frequencyStructural changesMeasurement errorsQualitative variables
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Multi-equation models
The black box problem can be solved by specifying a multi-equation model
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Time series models
These are based entirely on the history of the exchange rate:
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(cont.)




Time series models (cont.)
Exchange rates move predominantly in cycles with significant random variation
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Cycles of the US dollars effective exchange rate

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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 history
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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 available
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(cont.)




Market-based forecasting (cont.)
The reliability of market-based forecasts depends on the validity of the random walk hypothesis and the unbiased efficiency hypothesis
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Spot and lagged forward exchange rates (USD/AUD)

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The forward rate forecasting error as a percentage of the spot rate

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Judgmental forecasting
Judgmental forecasting takes into account all factors affecting exchange ratesIt is not based on a formula derived from a formal model
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Composite forecasting
Composite forecasting is based on two or more forecasts that are derived independentlyForecasting accuracy can be increased by pooling different forecasts
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Combining forecasts

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Why composite forecasting?
Different forecasters have different degrees of forecasting accuracyDiversification reduces the risk of large forecasting errors
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Forecasting performance evaluation
Performance out of sample is more meaningfulThe loss function is important
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Measures of forecasting accuracy
Mean absolute error (MAE)Mean square error (MSE)Root mean square error (RMSE)
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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 errors
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The prediction-realisation diagram

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G

C

F

D

E

B

A

H

Line of perfect forecast

Forecast change

Actual change




Technical analysis
Technical analysis comprises a variety of practices and procedures used to forecast exchange ratesIt ignores the role of fundamentals
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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 itself
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Kinds of charts
Line chartsBar chartsPoint and figure charts
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A bar chart

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Closing

High

Low

S

Time




Chart formations
Chartists study charts of exchange rate movements to identify certain patterns
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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 level
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Trendlines and trend channels

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(cont.)

S

Time

(a) Upward trend (bull market)




Trendlines and trend channels (cont.)

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(cont.)

S

Time

(b) Downward trend (bear market)




Trendlines and trend channels (cont.)

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S

Time

(c) Sideways trend (trading range)




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 move
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Creation of resistance and support levels

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Time

S




Flags
A flag is a continuation patternA flag occurs when a major trend is interrupted
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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 interpret
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Head and shoulders
This formation indicates the reversal of an upward trendA reverse head and shoulders formation implies the opposite
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(cont.)




Head and shoulders (cont.)

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Head

Neckline

Shoulder

Shoulder

Time

S




Reverse head and shoulders

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Head

Neckline

Shoulder

Shoulder

Time

S




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 charts
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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 peak
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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 otherwise
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(cont.)




A single moving average rule (cont.)

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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



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 versa
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Exchange rate

Moving average

Chapter_8

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