Fundamental analysis uses statistical models based on fundamental economic indicators to forecast exchange rates. These models are often quite complex, with many variations reflecting different possible economic conditions. These models include economic variables such as inflation, interest rates, money supply, tax rates, and government spending. Such analyses also often consider a country’s balance-of-payments situation (see Chapter 7) and its tendency to intervene in markets to influence the value of its currency.
Technique that uses statistical models based on fundamental economic indicators to forecast exchange rates.
Another method of forecasting exchange rates is technical analysis—a technique that uses charts of past trends in currency prices and other factors to forecast exchange rates. Using highly statistical models and charts of past data trends, analysts examine conditions that prevailed during changes in exchange rates and they try to estimate the timing, magnitude, and direction of future changes. Many forecasters combine the techniques of both fundamental and technical analyses to arrive at potentially more accurate forecasts.
Technique that uses charts of past trends in currency prices and other factors to forecast exchange rates.
Difficulties of Forecasting
The business of forecasting exchange rates is a rapidly growing industry. This trend seems to provide evidence that a growing number of people believe it is possible to improve on the forecasts of exchange rates embodied in forward rates. Difficulties of forecasting remain, however. Despite highly sophisticated statistical techniques in the hands of well-trained analysts, forecasting is not a pure science. Few, if any, forecasts are ever completely accurate because of unexpected events that occur throughout the forecast period.
Beyond the problems associated with the data used by these techniques, failings can be traced to the human element involved in forecasting. For example, people might miscalculate the importance of economic news becoming available to the market, placing too much emphasis on some elements and ignoring others.
So far, we have seen the importance of exchange rates between currencies, why companies try to manage shifting exchange rates, and the difficulties of forecasting rates. For a look at several approaches companies can use to counter the effects of a strong or weak currency, see this chapter’s Global Manager’s Briefcase titled, “Adjusting to Currency Swings.”
GLOBAL MANAGER’S BRIEFCASE Adjusting to Currency Swings
A strong and rising currency makes a nation’s exports more expensive. Here’s how companies can export successfully despite a strong currency.
■ Prune Operations. Cut costs and boost efficiency by downsizing staff and reworking factories at home to maintain production levels, and pursue customers abroad when export earnings decline.
■ Adapt Products. Win customer business and loyalty by tailoring your products to the needs of global customers and your company may retain their business despite your higher prices.
■ Source Abroad. Source abroad for raw materials and other inputs to the production process—your supplier will likely earn an extra profit and you’ll get a better deal than is available domestically.
■ Freeze Prices. A last resort may be to freeze prices of goods in foreign markets—this might boost overall profits if sales improve.
A weak and falling currency makes a nation’s imports more expensive. Here’s how companies can adjust to a weak currency.
■ Source Domestically. Source domestically for raw materials and components to lower the cost of production inputs, avoid exchange-rate risk, and shorten the supply chain.
■ Grow at Home. Fight for the business of domestic customers now that imported products of foreign competitors are priced high because of their relatively strong currencies.
■ Push Exports. Exploit the price advantage you get from your country’s weak currency by expanding your reach and depth abroad—people love a good bargain in all countries.
■ Reduce Expenses. Counteract the rising cost of imported energy by using the latest communication and transportation technologies to reduce air travel, cut utility bills, and slash shipping costs.
1. What are the two market views regarding exchange-rate forecasting? Explain each briefly.
2. Identify the two main methods of forecasting exchange rates. What are the difficulties of forecasting?
Evolution of the International Monetary System
So far in this chapter, we have discussed how companies are affected by changes in exchange rates and why managers prefer exchange rates to be stable and predictable. We saw how inflation and interest rates affect currency values, and in turn exchange rates, in different countries. We also learned that despite attempts to forecast exchange rates accurately, difficulties remain.
For all these reasons, governments develop systems designed to manage exchange rates between their currencies. Groups of nations have created both formal and informal agreements to control exchange rates between their currencies. The present-day international monetary system is the collection of agreements and institutions that govern exchange rates. In this section, we briefly trace the evolution of the current international monetary system and examine its performance.