Forecasting exchange rates and countering currency risk

"In the business world, the rear view mirror is always clearer than the windshield."
~Warren Buffet~
 
Companies who trade internationally are exposed to volatile foreign exchange markets by virtue of transactions that are due for future settlement in different currencies.

Accurate and reliable forecasting is therefore crucial if the company wants to evaluate the risks and benefits attached to the transactions they’re conducting – both on a trade-by-trade basis, but also in the context of the global business environment.
 
Only with the benefit of hindsight can any market participant properly evaluate the success of a particular transaction or hedge decision. Therefore, all one can do is construct an acceptable process by which forecasts – i.e. an expectation about the future value or movement in exchange rates – can be utilised to support the treasurer in making informed decisions.

The ability to accurately forecast potential future market movement is crucial in shaping the hedging decision making process, so a reliable in-house forecasting approach or forecasts provided by a 3^rd party specialist are pivotal. The alternative is basing decisions on incomplete, irrelevant or misunderstood information, which doesn’t fit within any appropriate hedging policy.
 
Corporates are constantly striving for better and more accurate ways of analysing and predicting future market movement to help them manage their exposures.

The ability to forecast future FX market movement requires the correct interpretation and evaluation of a number of issues.  There are two ‘pure’ approaches to forecasting foreign exchange rates:
 

1. Technical analysis
2. Fundamental analysis

 
Whether one is favoured, or both are adopted, is a matter of choice and experience. However, an appreciation of both concepts has merits to ensure considered and informed decisions are made. Both approaches have distinguishing features, but differ considerably in principle.
 
Technical analysis

Technical analysts care little for fundamental factors, instead focusing on the extrapolation, understanding and measurement of past price trends.

Many refer to technical analysis as an art rather than a science, which in many respects confirms its position as a polar opposite to fundamental analysis, which centres on the factual analysis of economic and other relevant determinants.

Technical analysis predicts price movement and future trend expectations by studying charts of past market action. In other words, its focus is on the effect of movement on price by utilising pattern recognition, mathematical modelling and analytical theory.

The three key principles of technical analysis are:
 

1. Market action discounts everything: market price discounts [factors] everything that is already known about the market or underlying asset/financial instrument. Technical analysis centres on the effect of movement on price.
2. Prices move in trends: pattern recognition is utilised and there is an expectation that a particular result will be effected when identified.
3. History repeats itself: Technicians believe the market is fractal and patterns repeat over different timeframes.

 
Technical analysis utilises a plethora of tools, including trend analysis, price gap identification, wave theory, indicators and number theory. The most popular concepts including moving averages, the drawing of trend lines, and momentum indicators.
 
It is fair to say that economists by and large have a negative view of technical analysis and often site evidence that simple random walk models are about as accurate as anything technical analysis has to offer.
However, a sound grasp of the approach will stand one in good stead when endeavouring to establish decision-making on a solid foundation of financial theory.

To many, the idea that price movement repeats is counterintuitive as people learn from mistakes. However, in its defence, the fact that financial crises have shaped the landscape since the Netherlands became over-enthusiastic fans of the humble tulip suggests history can and does repeat itself.

 
Fundamental analysis

A fundamental approach incorporates a wide range of data considered to be ‘fundamental’ in determining exchange rates.

Factors including political and financial considerations, statistics, economics, multi-asset analysis and supply and demand are used to determine the underlying impact on price movement and how expected changes in these variables could impact price moving forward.

Fundamental analysis is widely reported in the media and one will often read commentary centred on confidence indicators, production data, inflation, interest rates, and labour numbers (for example).

Analysis then regresses the data using sophisticated models to make projections on how actual and anticipated changes in these variables could impact on price.

Often one is looking at the impact divergence between corresponding datasets in order to determine the likely impact on future exchange rate volatility.

Purchasing power parity is a widely used concept, which specifies that equilibrium should ensure the relative value of currencies.
 
It’s clear that any forecast model will utilise concepts of art, science, and statistics. People tend to adopt parts of both techniques in order to keep an eye on the bigger picture, while honing in on a specific price to conduct detailed analysis.

Many prefer not to adopt their own methodology and instead lean on the expertise of a specialist provider, such as Currencies Direct Financial Markets. CDFM devises its own market forecasts, using statistical data and an aggregation of top performing forecasters to provide FX analysis over 3, 6 and 12 month periods. Other forecasts are similarly provided, collated and published by recognised information providers.
 
As one develops an acceptable forecasting strategy it’s important to evaluate the accuracy of a chosen method or provider over time. Many decide to adopt forecasts from a number of sources and aggregate this into a ‘total’ picture. This can be further enhanced by adding weighting to respective sources based on performance over time. It’s important not to get trapped by short-termism and instead focus on performance and accuracy over longer timeframes.
 
For many, a simple forecast will be sufficient to support decision making.

For others, a much more technical and detail-orientated approach will be necessary to fully clarify the outlook with regards to the corporate’s own forecast, it’s hedging needs, the risks it faces and the prevailing forecasts of whomever it uses to provide market forecasting services.

For example, regulatory change is making it possible to get a clearer picture on market liquidity and volume. Overtime, as more data is collected and made available, a more detailed analysis and comparison will be able to support decision making.

Furthermore, implied volatility distribution by the options market will often provide confirmation or a contrary outlook on forecasting by leveraging price prediction available in that market.

Volume-based trading is used in other markets and is gradually shifting over to FX; data from the Commodity Futures Trading Commission’s Commitments of Traders (COT) delays positioning and volume utilising information from the futures markets.

However, while this can be useful and provide a strong gauge of price action, there can be delays in its release and subsequent analysis can be technical and tricky. Often, corporate treasurers will seek a number of sources before allocating their own weighting as forecasting FX movement as accurately as possible is crucial to support the business in hedging its exposures optimally.
 
A major mistake some treasurers make is to misinterpret the time horizon over which they are executing their hedging requirements.

If the company has exposure through months 1 to 12, it would be an error to look at one particular timeframe – say 12 months – and use that as the forecasting benchmark. Instead, it’s important to better grasp the rates available for hedging at different tenors (time horizons).

It makes sense in such instances to look at the forward curve – which determines the interest rate differential between two currencies – as much if not more than the market view of whether price is going up or down. The treasurer can then require pricing from the broker/bank at each time horizon to review their view and price discovery.

It is difficult to optimise decision making and predict future market movement, often due to an inability to digest increasingly complex information and make reliable predictions as a result of either an over-abundance or complete lack of directly applicable information.

CDFM strives to provide a plethora of tools and services to digest the complex FX markets and support corporate treasury decision making.

Forecasting future FX markets is an important step in any hedging strategy.

Without a benchmark it will be difficult to assess the effectiveness of the hedge/hedge decision.

Furthermore, without a clear determination of expected market movement the corporate treasurer’s ability to make reasoned and sound decisions regarding the what, where and why of the hedge is limited.

FX market analysis done properly – utilising the expertise of experts, such as CDFM – offers effective and easy ways to keep your finger on the pulse of the FX markets while making informed decisions.

The suitability of a forecast that utilises in-house technical and/or fundamental techniques as opposed to one that also incorporates or relies completely on an ‘independent’ provider is dependent on the specific needs of the corporate.

CDFM is positioned to support corporates and improve their risk management decisions and strategies irrespective of underlying market conditions and uncertainty.

If you would like to discuss your company’s approach to FX analysis and risk management please get in touch with our team on Business@currenciesdirect.com or call 44 (0) 20 7847 9288.  
 
*Risk warning FX derivative products can carry a high level of risk and may not be appropriate and/or suitable for everyone. Please take all reasonable steps to understand certain key concepts before transacting in FX derivative products. More information is available at currenciesdirect.com/options and in our Product Disclosure Statement.