testing the rate forecasting consistency of major foreign currency futures

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Testing the rate forecastingconsistency of major foreigncurrency futuresTheodor Kohers aa Professor of Finance and International Business atMississippi State University ,Published online: 21 Jun 2007.

To cite this article: Theodor Kohers (1987) Testing the rate forecasting consistencyof major foreign currency futures, The International Trade Journal, 1:4, 359-370,DOI: 10.1080/08853908708523624

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TESTING THE RATE

FORECASTING CONSISTENCY

OF MAJOR FOREIGN

CURRENCY FUTURES

Theodor Kohers

T h i s paper examines t h e forecasting accuracy of currency futures

markets i n Canadian Dollars, British Pounds, Japanese Y e n , German

Marks, and Swiss Francs i n predicting t h e actual spot rates that will exist in the spot market for these currencies. A second objective is t o determine if

the accuracy of t h e forecast is related to t h e t i m e t o maturity of t h e currency

futures contract relative to t h e actual spot rate for that currency. T h e results

indicate that the currency futures market appears t o be a reasonably good

forecaster of future currency spot rates.

I. INTRODUCTION

The movement toward floating exchange rates in 1971 greatly

increased the risk of international business because market forces (that is,

the demand for and supply of foreign exchange) are generally left free to

determine the spot exchange rate. The anticipated exchange rate change is,

therefore, an important factor which influences the expected return on a

Theodor Kohers is Professor of Finance and International Business at Mississippi State University.

ISSN. 0885-3908, T H E I N T E R N A T I O N A L T R A D E I O U R N A L , Volume I. No. 4, Summer 1987 3-59

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THE 1NTERNATIONAL TRADE JOURNAL

foreign investment. The unanticipated exchange rate change, in like

manner, is a critical component in the risk of foreign investment. Fortunately, multinational firms may reduce the risk of fluctuations in

currency valuation by hedging in both the forward and futures markets. While the hedging function of forward and futures markets is very valuable,

these markets also provide free public forecasts of future spot rates. International businesses could possibly use these forecasts to make better

decisions in situations where hedging is not appropriate.

This study provides an analysis of the relative price-forecasting

accuracy of selected currency futures markets. Special emphasis is given to the role of expectations in exchange rate determination. While numerous

studies have reported on the relationship between forward foreign exchange markets and spot foreign exchange markets, very little work has

been done on the usefulness of the futures currency market to predict future

spot rates. (For examples see Bilson, 1976; Cornell, 1981; Cox, et al, 1981; Denis, 1776; French, 1783; and Frenkel, 1987.) Consequently it would be of interest to examine if the currency futures market for the Canadian Dollar,

the British Pound, the Japanese Yen, the German Mark, and the Swiss Franc

is able to provide accurate public forecasts of future spot rates.

11. BACKGROUND

The International Monetary Market of Chicago was organized in 1972

as a division of the Chicago Mercantile Exchange to facilitate trading in foreign currency futures contracts. This market offers speculators and hedgers an alternative to the forward foreign exchange market. A "futures" market differs from a "forward" market in terms of institutional structure

rather than concept. Futures trading takes place on organized exchanges and with standardized contracts; in contrast, forward trading is non-

standard contracts, usually of a large size, and is negotiated directly between banks and their clients.

While the hedging function of the currency futures markets is very valuable, these markets also provide continuous free public forecasts of

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Kohers: Testing T h e Rate Forecasting Conrzrtency . . . 361

future currency spot rates. The futures markets give both direction and magnitude of expected currency spot rate levels established by supply and demand expectations of many individuals. Accuracy and timeliness of these forecasts are important factors if these markets are to serve the public. One aspect of the accuracy function is the relative precision that the forecasts provide over a variety of time spans to expiration of the futures contract.

An examination of the degree of accuracy of currency futures market forecasts would be of interest for the following reasons. First, one could determine how successful participants in this market are in predicting future currency spot rates. Since these participants are believed to be professional traders with more access to information than is available to the average investor, it could be reasoned that their predictions should be reasonably accurate. Should these markets represent accurate forecasts of future currency spot rates, then this added function would contribute to a more positive public image of these markets. Second, financial managers could use these predictions for future planning, especially in terms of investment decisions, capital budgeting and financing decisions in addition to the hedging function. Knowledge of future currency spot rates can affect a decision at hand for these individuals or firms. Finally, accuracy of forecasts can be important for policy makers. They could use the currency futures markets to assess the effects of policy changes upon expectations of future currency spot rates.

Therefore, the purpose of this study is to examine the forecasting accuracy of currency futures markets in Canadian Dollars, British Pounds, Japanese Yen, German Marks, and Swiss Francs in predicting the actual spot rates that will exist in the spot market for these currencies.

111. STATISTICAL METHODOLOGY A N D DATA

All relevant information available to the participants in the currency futures markets is utilized in the preparation of a forecast of future interest rates as exhibited by the prices quoted in the futures market. With the present research an attempt is made to discern if the currency futures markets in Canadian Dollars, British Pounds, Japanese Yen, German Marks, and Swiss Francs are relatively good predictors of their respective future spot rates.

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362 THE INTERNATIONAL TRADE JOURNAL

Data for the rates of futures contracts were obtained from quotations

on the International Monetary Market (IMM) for the Canadian Dollar, the

British Pound, the Japanese Yen, the German Mark, and the Swiss Franc for

contracts which expire in six months or less than six months. These rates

were recorded on a weekly basis, resulting in 26 observations per contract.

All future contracts for the five currencies related to the March and

September spot rates were included. More specifically, 26 predictions (one

per week) were examined for each one of the eleven semi-annual periods

included in this study, that is starting with the March-September 1980

period to the September 1980-March 1981 period, et cetera to March-

September 1985. For example, the spot rate on September 18,1985 in U S .

dollar equivalent for the British Pound was 1.444. How well this spot rate

was predicted --one week before, two weeks before, ... 26 weeks before

September 18,1985-- making use of the futures market is the subject of this

study. The futures market predicted the spot rate to be 1.3065, 1.3695 and

1.1315 one week before, two weeks before, and 26 weeks before, res-

pectively. The absolute percentage error in the forecast [for example,

(1.3065 - 1.444)/1.444 = 9.52%] over a period of time is usedas a measure of

forecast accuracy. All rates, that is, future and spot, were obtained from

quotations in the foreign exchange section of The Wall Street Jownal .

A similar approach to that presented by others is used to analyze

market forecast efficiency (Bilson, 1977; Kaserman, 1973; and Stockman,

1978). Errors metrics are used since they measure the level and dispersion

of the forecast errors between the implied currency futures market rate and

the actual currency spot rate. The primary statistic used is the absolute

percentage forecast error, which is defined as

where

et,, = the absolute value of the percentage forecast error for the

currency futures market rate for time t;

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Kohers: Testing T h e Rate Forecasting Consis tency. . . 3 63

St+, = the currency spot rate n periods into the future from time t, and

Ft,, = the currency future rate at time t for delivery n periods in the

future

This statistic measures the magnitude of the dispersion between the

actual currency spot rate and what was predicted by the currency futures

market. Also, the average forecasting errors and their standard deviations

are presented by semi-annual periods examined.

IV. FINDINGS

The results of the forecast accuracy of the currency futures market are

presented in Tables I-V. There was considerable variation in the range of

percentage forecast errors by semi-annual period for each currency. For

example, the minimum "high" forecast error for the Canadian Dollar over

the 11 semi-annual periods ranged from 0.55 percent, which occurred

during the March-September 1983 period, to a maximum "high" error of

4.99 percent during the March-September 1982 time frame. However, the

mean of the eleven-period percentage forecast error was an amazingly low

1.46 percent. The percentage forecast errors over the entire 1 1 time periods

ranged from a low of zero percent to a high of 4.77 percent. (For details, see

Table I, page 365.)

The forecasting accuracy of the futures market for the British Pound

was considerably lower than it was for the Canadian Dollar. Over the 11

periods examined, the minimum "high" forecast error of 4.84 percent

occurred during the September-March 1784 time span, while the maximum

"high" of 24.34 percent occurred during the March-September 1981 period.

The mean forecast error for the entire period from March 1780 to

September 1985 turned out to be 5.72 percent. The range of errors over this

time frame was from a low of zero percent to a high of 24.34 percent. (For

details, see Table 11, page 366.)

The futures market forecasting accuracy of the Japanese Yen was

comparable to that of the British Pound. The mean forecast error over the

entire period examined, that is, from March 1980 to September 1785, was

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364 THE INTERNATIONAL TRADE JOURNAL

5.27 percent, with a minimum "high" forecast error of 5.34 percent during

the September-March 1981 period and a maximum "high" of 16.03 percent

occurring during the March-September 1980 time frame. The range of

errors over the March 1980 to September 1985 period was from a low of

0.01 percent to a high of 16.03 percent. (For details, seeTable 111, page 367.)

The futures market results for the German Mark were comparable to

those of the British Pound. The minimum "high" forecast error of 2.92

percent occurred during the March-September 1980 period, while the

maximum "high" of 22.80 percent occurred during the March-September

1984 time frame. The mean forecast error for the entire period from March

1980 through September 1985 turned out to be 5.97 percent, with a range of

forecasting errors from 0.02 percent to a high of 22.80 percent. (For details,

see Table IV, page 368.)

Finally, the futures market forecasting accuracy of the Swiss Franc was

also quite similar to that of the British Pound. The minimum "high"

forecast error ranged from 6.07 percent, which occurred during the

September 1983-March 1984 period to a maximum "high" error of 21.70

percent during the March-September 1984 time frame. The mean of the

eleven-period percentage forecast error was 6.00 percent and the range of

errors extended from a low of 0.00 percent to 2 1.70 percent. (for details, see

Table V, page 369.)

V. SUMMARY A N D CONCLUSIONS

This study examined whether the currency futures markets for the

Canadian Dollar, the British Pound, the Japanese Yen, the German Mark,

and the Swiss Franc were able to predict the actual currency spot rates that

would exist in the markets for those respective currencies.

On the whole, the currency futures market appears to be a reasonably

good forecaster of future currency spot rates. Therefore, participants in this

market can use it with a certain degree of confidence. Also, non-participants

could use this market to gauge the future direction and magnitude of foreign

currency exchange rate changes.

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TABLE I

Average Forecast Error of the Canadian Dollar Futures Market Over a 26-Week Forecast Horizon

S e m ~ - Annual Forecast Period,

Mean Forecast Error

Standard Deviation.

March - Sept. 1985

Sept. 84 - March 1985

March - Sept 1984

Sept 83 - March 1984

March - Sept. 1981


March - Sept. 1982


March - Sept 1981


March - Sept 1980

Average: March 80 - Sept. 85

0 60%

0 9857

0 9657

0 9057

0 17%

0 6 1 4

164%

0 8 4 4

0 8557

0 54%

05157

Total Range

Range.

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TABLE I1

Average Forecast Error of the British Pound Futures Market Over a 26-Week Forecast Horizon

Semi - Annual Forecast Period:

Mean Forecast Error:

Standard Deviation: Range:

March - Sept. 1985


March - Sept. 1984


March - Sept. 1983


March - Sept. 1982


March - Sept. 1981


March - Sept. 1980

----------------- Average: March 80 -Sept. 85

5.70%

2.69%

4.54%

1.59%

1.51%

4.90%

2.03%

1.97%

8.36%

1.38%

2.80%

T o t a l R a n g e :

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TABLE I11

Average Forecast Error of the Japanese Yen Futures Market Over a 26-Week Forecast Horizon




March - Sept 1985


March - Sept. 1984


March - Sept 1983


March - Sept 1982


March - Sept 1981


March - Sept. 1980


2.19%

3.00%

4.27%

0.89%

1.55%

4.58%

4.86%

3.87%

3.71%

1.49%

4.19%

Total Range:

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TABLE IV

Average Forecast Error of the German Mark Futures Market Over a 26-Week Forecast Horizon




March - Sept. 1985


March - Sept. 1984


March - Sept. 1983


March - Sept. 1982


March - Sept. 1981


March - Sept. 1980

Average: March 80 -Sept. 85

4.3 1 %

3.43%

5.56%

1.79%

4.25%

1.96%

3.62%

2.94%

3.31%

4.64%

0.88%

T o t a l R a n g e :

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TABLE V

Average Forecast Error of the Swiss Franc Futures Market Over a 26-Week Forecast Horizon



Standard Deviation:

March - Sept. 1985


March - Sept. 1984


March - Sept. 1983


March - Sept 1982


March - Sept 1981


March - Sept 1980


4.95 %

4.58%

6.43%

1.54%

2.75%

2.10%

5.94%

2.23%

2.66%

5.47%

1.83%

Total Range:

Range:

2.37% - 19.05%

0.83% - 16.84%

1.47% - 21.70%

0.20% - 6.07%

0.32% - 8.85%

0.05% - 6.86%

0.19% - 18.45%

0.00% - 7.74%

0.65% - 9.58%

0.28% - 17.55%

0.00% - 7.89%

..................... 0.00% - 21.70% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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T H E I N T E R N A T l O N A L T R A D E J O U R N A L

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Ph.D. dissertation, University of Chicago, 1976.

Bilson, J.F., and Levich, R.M., "A Test of the Forecasting Efficiency of

the Forward Exchange Market," New York University Working Paper

NO. 77-61, 1777.

Cornell, B., and Reinganum, M.R., "Forward and Futures Prices:

Evidence from the Foreign Exchange Markets," Journal of Finance,

Volume 36,1981, pages 1035-1045.

Cox, J.C., Ingersoll, J.E., and Ross, S.A., "The Relationship Between

Forward and Futures Prices," Journal of Financial Economics, Volume 9, 1981, pages 321-346

Denis, J., "How Well Does the International Monetary Market Track

the Interbank Forward Market?'' Financial Analysts Journal, Volume

32, 1776, pages 50-54.

French, K.R., "A Comparison of Futures and Forward Prices," Journal

of Financial Economics, Volume 12, 1783, pages 311-342.

Frenkel, J.A., "The Forward Exchange Rate, Expectations and the

Demand for Money: The German Hyperinflation," American Eco-

nomic Review, September 1977, pages 653-670.

Kaserman, D.L., "The Forward Rate: Its Determination and Behavior

as a Predictor of the Future Spot Rate," Proceedings of the American

Statistical Association, 1773, pages 417-422.

Stockman, A.C., "Risk, Information, and Forward Exchange Rates," In

Frenkel, J.A. and Johnson, (eds.), T h e Economics of Exchange Rates. Reading, Mass.: Addison-Wesley Publishing Company, 1778.

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testing the rate forecasting consistency of major foreign currency futures

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