chapter 8 exchange rate forecasting, technical analysis and trading rules

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 needed• To illustrate forecasting techniques• To explain how to evaluate the performance of

forecasters

8-2

(cont.)



Objectives (cont.)

• To demonstrate how technical analysis is used to generate buy and sell signals

• To explain how filter rules and moving average rules work

8-3



Definition

• Forecasting is a formal process of generating expectation

• Expectations are implicit forecasts

8-4



Why do we need exchange rate forecasting?

• Spot speculation • Uncovered interest arbitrage • Spot-forward speculation• Option speculation• Hedging• Investment and capital budgeting

8-5

(cont.)



Why do we need exchange rate forecasting? (cont.)

• Financing decisions • Pricing decisions • Strategic planning • Macroeconomic conditions• Central bank intervention

8-6



Econometric forecasting models

• These are models that are specified on the basis of economic theory and estimated by an econometric method

• They are classified into single-equation and multi-equation models

8-7



Single-equation models

• The exchange rate (or its rate of change) depends on one or more variables:

tnnttt

tnttt

XaXaXaaS

XXXfS

,,22,110

,,2,1 ),(

8-8



Examples of single-equation models

110

110

10

)(

)(

tt

tt

tt

FaaS

iiaaS

PPaaS

8-9



Problems of single-equation models

• The ‘black box’ problem• Forecasting the explanatory variables• Data frequency• Structural changes• Measurement errors• Qualitative variables

8-10



Multi-equation models

• The ‘black box’ problem can be solved by specifying a multi-equation model

8-11



Time series models

• These are based entirely on the history of the exchange rate:

ttttt

ntttt

S

sSSfS

εφγμ

),( 21

8-12

(cont.)



Time series models (cont.)

• Exchange rates move predominantly in cycles with significant random variation

8-13



Cycles of the US dollar’s effective exchange rate

8-14



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

8-15



Market-based forecasting

• Using the current market spot and forward rates as forecasters for the future spot rate

• This means that market-based forecasts are free and readily available

8-16

(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

8-17



Spot and lagged forward exchange rates (USD/AUD)

8-18



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

8-19



Judgmental forecasting

• Judgmental forecasting takes into account all factors affecting exchange rates

• It is not based on a formula derived from a formal model

8-20



Composite forecasting

• Composite forecasting is based on two or more forecasts that are derived independently

• Forecasting accuracy can be increased by pooling different forecasts

8-21



Combining forecasts

kkc

c

c

SSS

SwSwS

SSS

ˆβˆβˆ

ˆˆˆ

2

ˆˆˆ

11

2211

21

8-22



Why composite forecasting?

• Different forecasters have different degrees of forecasting accuracy

• Diversification reduces the risk of large forecasting errors

8-23



Forecasting performance evaluation

• Performance out of sample is more meaningful• The loss function is important

8-24



Measures of forecasting accuracy

• Mean absolute error (MAE)• Mean square error (MSE)• Root mean square error (RMSE)

8-25



Magnitude versus direction

• Sometimes it is more important to predict the direction rather than the magnitude of the change

• The prediction-realisation diagram can be used to represent magnitude and direction errors

8-26



The prediction-realisation diagram

G

C

F

D E

B

A

H

Line of perfect forecast

Forecast change

Actual change

8-27



Technical analysis

• Technical analysis comprises a variety of practices and procedures used to forecast exchange rates

• It ignores the role of fundamentals

8-28



Rationale for technical analysis

• Exchange rates are determined by supply and demand

• Supply and demand are governed by rational and irrational factors

• Changes in trend are caused by shifts in supply and demand

• History repeats itself

8-29



Kinds of charts

• Line charts• Bar charts• Point and figure charts

8-30



A bar chart

Closing

High

Low

S

Time

8-31



Chart formations

• Chartists study charts of exchange rate movements to identify certain patterns

8-32



Trendlines and trading ranges

• Trendlines connect ascending bottoms and descending tops

• The market is in a trading range when the tops and bottoms are at the same level

8-33



Trendlines and trend channels

S

Time(a) Upward trend (bull market)

8-34

(cont.)



Trendlines and trend channels (cont.)

S

Time(b) Downward trend (bear market)

8-35

(cont.)



Trendlines and trend channels (cont.)S

Time

(c) Sideways trend (trading range)

8-36



Support and resistance levels

• A support level is the bottom of a market swing• A resistance level is a point where the market peaks

and the exchange rate reverses an upward move

8-37



Creation of resistance and support levels

Time

S

1t 2t 3t

2S

1S

8-38



Flags

• A flag is a continuation pattern• A flag occurs when a major trend is interrupted

8-39



Triangles

• An ascending triangle appears when buyers come to the market at progressively higher levels. Otherwise it will be a descending triangle

• A symmetrical triangle is difficult to interpret

8-40



Head and shoulders

• This formation indicates the reversal of an upward trend

• A reverse head and shoulders formation implies the opposite

8-41

(cont.)



Head and shoulders (cont.)

Head

Neckline

Shoulder Shoulder

Time

S

8-42



Reverse head and shoulders

Head

Neckline

Shoulder Shoulder

Time

S

8-43



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

8-44



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

8-45



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

8-46

(cont.)



A single moving average rule (cont.)

1.60

1.70

1.80

1.90

2.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Exchange rate

Moving average

8-47



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

8-48

chapter 8 exchange rate forecasting, technical analysis and trading rules

Documents

moosa slides

international finance

afaf moosa objectives

analytical approach

mcgrawhill australia

afaf moosa singleequation

afaf moosa examples

afaf moosa problems