Forecasting Exchange Rates

I tell the future. Nothing easier. Everybody's future is in their face. But who can tell your past—eh? Nobody!. . . I can't tell the past and neither can you. If anybody tries to tell you the past, take my word for it, they're charlatans! Charlatans! But I can tell the future.

Fortune-teller in Thornton Wilder's The Skin of Our Teeth, Act Two

Reliable estimates of future spot exchange rates are critical inputs to the decisionmaking process in international business for such key areas as (1) hedging overall corporate exposure to foreign exchange (FX or forex) risk, (2) protection of the value of expected profits from foreign subsidiaries, as well as of their remittances to the parent, (3) selection of the cheapest financing source, (4) optimization of multicurrency cash management, (5) evaluation of foreign long-term investment proposals, and (6) international sourcing/procurement decisions. Optimal decisions require reliable exchange rate forecasts over varying time spans. Similarly, for globally reaching financial institutions continuously optimizing their assets–liabilities portfolios in the time x currency space, exchange rate forecasts (along with interest rate forecasts) are also critical informational inputs.

This chapter considers the validity of generating model-based forecasts when market-based forecasts are available free of charge in the context of floating exchange rates. This is the old question, “Can we beat the market?” which ...

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