Chapter 8

Chapter 8
Exchange Rate Forecasting,

Technical Analysis and Trading Rules
Objectives
To explain why exchange rate forecasting is needed
To illustrate forecasting techniques
To explain how to evaluate the performance of
forecasters
(cont.)
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
8-2
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
(cont.)
8-5
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 multiequation models

8-7
Single-equation models
The exchange rate (or its rate of change) depends
on one or more variables:
St f ( X 1,t , X 2,t X n,t )

St a0 a1 X 1,t a2 X 2,t an X n,t

8-8
Examples of single-equation models
S t a0 a1 ( P P )t
S t a0 a1 (i i )t 1
St a0 a1Ft 1

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:
St f ( St 1 , St 2 st n )
St t t t t
(cont.)
8-12
Time series models (cont.)

Exchange rates move predominantly in cycles with
significant random variation

8-13
Cycles of the US dollars 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
(cont.)
8-16
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
Sc
Sc
S1 S2
2
w1S1 w2 S2
Sc 1S1 k Sk

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

Actual change
D
Line of perfect
forecast
H
A
B
Forecast change
C
G
F

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
S
High
Closing
Low
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)
(cont.)
8-34
Trendlines and trend channels (cont.)

S
(b) Downward trend (bear

market)
Time
(cont.)
8-35
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

S
S2
S1
t1
t2
t3

Time
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
(cont.)
8-41
Head and shoulders (cont.)

S
Head
Shoulder
Shoulder
Neckline
Time
8-42
Reverse head and shoulders

S
Neckline
Shoulder
Shoulder
Head
Time
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
(cont.)
8-46
A single moving average rule (cont.)

2.00
1.90
Exchange rate
1.80
1.70
Moving average
1.60
1
10
11

12
13
14
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

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Chapter 8

Exchange Rate Forecasting,

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Why do we need exchange rate forecasting?

Why do we need exchange rate forecasting?

Copyright 2010 McGraw-Hill Australia Pty Ltd

Econometric forecasting models

Copyright 2010 McGraw-Hill Australia Pty Ltd

St f ( X 1,t , X 2,t X n,t )

Copyright 2010 McGraw-Hill Australia Pty Ltd

Examples of single-equation models

Copyright 2010 McGraw-Hill Australia Pty Ltd

Problems of single-equation models

The black box problem

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Time series models

Time series models (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Cycles of the US dollars effective exchange

Copyright 2010 McGraw-Hill Australia Pty Ltd

Problem with time series models

Copyright 2010 McGraw-Hill Australia Pty Ltd

Market-based forecasting (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Spot and lagged forward exchange rates

Copyright 2010 McGraw-Hill Australia Pty Ltd

The forward rate forecasting error as a

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Why composite forecasting?

Copyright 2010 McGraw-Hill Australia Pty Ltd

Forecasting performance evaluation

Copyright 2010 McGraw-Hill Australia Pty Ltd

Measures of forecasting accuracy

Copyright 2010 McGraw-Hill Australia Pty Ltd

Magnitude versus direction

Copyright 2010 McGraw-Hill Australia Pty Ltd

The prediction-realisation diagram

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Rationale for technical analysis

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Trendlines and trading ranges

Copyright 2010 McGraw-Hill Australia Pty Ltd

Trendlines and trend channels

Trendlines and trend channels (cont.)

(b) Downward trend (bear

Trendlines and trend channels (cont.)

Support and resistance levels

Copyright 2010 McGraw-Hill Australia Pty Ltd

Creation of resistance and support levels

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Head and shoulders

Head and shoulders (cont.)