The Performance of Models for Exchange Rate Forecasting Essay

Introduction

Foreign trade involves the use of different currencies & thus for the efficient use of such currencies, a clear conception about rate of exchange is essential. According to finance, the foreign exchange rate is the price of one currency in terms of another currency. It is determined in the foreign exchange market, which is the market where different currencies are traded. For example, if the Japanese rate of exchange is 102 Japanese yen in relation to USA $, it indicates that JPY 102 values equal to US $1. Exchange rate is of several types. Like- spot, forward or future exchange rates etc.

Exchange rate determination

Mcconnel, C. R., Brue, S. L. (2005) stated that like most other prices, FER varies from week to week & month to month according to the forces of supply & demand & foreign currencies are traded at the retail level in many banks & firms specializing in that business. This condition can be focused by the following diagram:

Classification of models of exchange rate

According to most petitioners, maximum RE models are based on abstract & long-term equilibrium conditioned. In case of equilibrium exchange rate model, the rate is imposed by presumed equity of the model. Or, diversified assumptions & conditions produce diversified equilibrium & exchange rate for the equal economy. Several related issues are:

Purchasing-power parity

The PPP is the one of the oldest methodology of assuming about rate of equilibrium exchanges. In the short-run, market-determined exchange rates are highly volatile in response to money policy, political events & changes in expectations. So, under this concept, a nation’s exchange rate will tend to equalize the cost of buying traded goods at home with the cost of buying those goods in abroad.

Mcconnel, C. R., Brue, S. L. (2005) expressed that the PPP doctrine also holds that countries with high inflation rates will tend to have depreciating currencies. For example- if country A’s inflation rate is 10% while inflation in country B is 2%, the currency of country A will tend to depreciate relative to that of country B by difference in inflation rate or 8% annually.

There are so many reasons for the backward nesses of PPP theory. Like:

• Introduction of non-tradable objects.
• Transportation.
• Trade restrictions & barriers.
• Differences in prices & customer preferences.

A popular version of PPP is known as “Relative purchasing power parity” that emphasizes on variation in prices & thus in exchange rates. It more closely related to the macroeconomics concept or models, like- monetary models & inflation theory.

Nominal & REER

Another concrete approach is nominal or real effective exchange rates that prepare to implement the equilibrium values:

• “Real exchange or nominal exchange rate” is combined by the ratio of national to overseas prices or the interest by which a nation can purchase domestically relative to that it can purchase in foreign currency, while it is renewal into own country’s currency.
• According to “EER or Effective interest rate”, the overall or international foreign exchange value of a currency is estimated by a specific index & the weights of such indices are come from a nation’s global pattern of trade that can be termed as “trade weighted” index.
• The above key issues can be further indicated as “REER or Real effective interest rates” that is considered as the indicator of competitiveness & the major issue in the rates of equilibrium.

Mcconnel, C. R., Brue, S. L. (2005) refers that the different methodologies of REER are targeted to gain different competitiveness like JPMorgan utilize price of producer & the IMF estimates various indices by considering significant methods involving labor costs.

A variation in weighting system is also allowed, like- JPMorgan use of fixed weight on the basis of bilateral trade. REER is generally constant over time as it often experiences worldwide monetary shocks. But it may change over time because of productivity in the non-tradable sectors. Along with productivity, per capita income, T/T, position of foreign assets is vital for its advancement.

Other considerations

Grauwe, P. D., and Verfaille, G. (1988) have established “Fundamental equilibrium exchange rate or FEER” that considers the internal & external balance that tends to derive the full employment as well as a little inflation along with a sustainable accounting balance that has been set by current account size regarding the financing opportunity. Thus this approach is called “macroeconomic balance” that does not exactly define equilibrium of monetary market rather than to estimate the amount of exchange rate must be converted to capture the current account that is sustainable & based on the trade model.

Bodie, Z. Kane, A. and Marcus A. J. (2005) stated that the IMF uses this approach in terms of CGER or Coordinating group of exchange rates fix the REER which is stable with that “appropriate” account as output that idealizes both current account condition as well as the equal savings- investment position while the latter is based on the econometric model involving fiscal balance, income, interest and many demographic factors.

Extension of this concept includes behavioral components like productivity and real interest distinction. Means, over time FEER would evolve or equilibrium numbers would be in regular change. Another is abundance of judgmental establishment of balance of sustainable current account and reveal the REER behavior by regular, transitory and long- run impacts which depends on the effectiveness of fundamental variables like- traded objects, net overseas assets, open economy etc. Such models can allow the ER adjustments while flowed from an equilibrium stage.

Samuelson, P. A., Nordhaus, W. D. (2006) expressed that a Balance of payment model is important as it assumes that ER is determined by private supply and demand with no government intervention. A better example is what happened in 1990 when the German central bank decided to raise interest rates to curb inflation. The less expensive currency serves the nation’s commodities highly affordable in the international market rather than expensive imports. Similar to PPP, this model largely focuses on tradable items rather than vital capital flows.

The vast business of financial assets has replaced the traditional looks of currencies and the proportion of ER from multi- border trading to the extension of transaction in currency produced from exchanging commodities. So, the asset- market model identifies currencies as the important demonstrator a powerful co- relative with other equities market. Here, money can be traded at spot market as representing the current rate and at option market as the ER derivatives.

Evaluation of performance

Keat, P. G., Young, P. K. Y (2003) mentioned that the performance of ER models can be evaluated by a number of means. Like:

• According to Meese and Rogoff, rather than forecasting, the models should be evaluated with generating the small mean-square errors rather than simple and random forecast without any change.
• Models are also useful in concocting the ER by horizon although it is doubtful that those are not very much effective forecasting measures while ER are distant with fundamentals, those are better the ER that will come back to the origin.
• Many models used for weighting current fundamentals future values of ER usually put comparatively small on weight and expectations. The achievement of current values can impact ER in indirect way through affecting the expected forecasted rate while the marketers generally use other sorts of information for composing expectations rather than realization method. So, the implication of models would have little impact on ER that can be solved through the expression of ER as current reduced value of present and future fundamentals.
• Additionally, the popular Campbell- Shiller method is imperfect for evaluation since a few essential fundamentals in money, exchange risks are not being recognized through econometrician.
• As the ER is assumed to focus the present value of existing and forecasted fundamentals, it is more particular to present the observed fundamentals. And it fluctuates with the forecasted ‘unobserved’ fundamentals, for this, it should not be expected as a perfect forecaster of the observed values.
• The volatility of PV is less practically than the ER volatility. But it should be done in the opposite way. As the researches may not posses’ sufficient data that are used by the marketers in forecasting, such forecast would have more variance rather than marketplace.
• Campbell- Shiller technique results in all available market information that is reflected in the price of assets but ER shows single and true fundamental report regardless the econometrician identified components.
• Models can be developed without research of macroeconomic that focus on financial policy including interest rates responding inflation, result gap.
• In relation to Mark’s nominal interest rate adjustments allows the lack of knowledge of the agents about policy of central bank. But this may not take part a major role to explain the ER movements.
• According to Bacchetta and van Wincoop, more emphasize should be given on inferring information to form ER. Agents must focus on “higher- order beliefs”. Introduction of “unobserved fundamentals” are also required.
• Many ER models emphasize largely on trade –based relation and little focus on financial market dominants that cause a modeling weakness as the influence would be indirect mostly and express that direct influences are relatively less.

Results on performance of ER models

Samuelson, P. A., Nordhaus, W. D. (2006) stated that simply it is difficult for any model to express each of the requirements of economy for recognizing the ER movements, specifically for the integrated international and financial market. Thus several outputs of ER models are as following:

• Results in external imbalances adjustments and entrusting clear and effective international monetary and financial system functions.
• According to Samuelson and many other authors, REER works well in case of tradable goods as the real wages will increase at the same line of productivity and make upward force on similar prices of non- tradable objects.
• Many famous monetary organizations, like World Bank adopts PPP for making the global comparisons of GNP by which a country’s domestic goods or services are valued at a common currency across national boundaries.
• This measure is also effective in computing the costs to purchase a relatively standard basket among 120 countries that has been proved as a real and fruitful idea.
• The models are also effective and having significant implications for assessing the RE level. Because, a slight change can express a significant distortion in computation or lead under- valuation.
• The use of different structures of model in private sector often offers important aspects than academic research. For example, forecasting a private sector would disclose a nominal bilateral agreement as the indicator of successful business opportunity.
• HSBC bank maintains a stable long-run external balance.
• JPMorgan also utilizes behavioral equilibrium ER model along with the initials of productivity, open economy and T/T for constructing the real equilibrium ER in which the model offers a currency measurement regarding over and under- valuation. To correct the errors, short-term dynamism is considered. Thus, the company makes a fair valuation of currencies, equalizing a stable domestic and foreign ER based on issues like- probable risks, outward prices and rate of interest.
• Another behavioral ER model is GSDEEMER of Goldman Sachs, which evolves on long-run ER equilibrium key to relative output or productivity, Terms of Trade or global investment position, concerns that nominal rate bears entire adjustment burden to the equilibrium of medium time frame.

Variation in results

Several models generate several results of equilibrium because:

• Each model may target different initial variables and offer different steps. One can identify a minimum under-valuation of a particular currency and other may find out over- valuation. A round or cyclical factor may impact on ER so the models can idealize and convert different results from that models without the previous performance. As there is no “right model”, a particular range should be used.
• Each model distorted by methodological flaws which are greater in creating impact than others. Such as, many emphasize on real than nominal exchange rates, some on bilateral than multilateral indices or some use base time for starting by using price deflators.
• It is necessary to understand the equilibrium by statistical measures involving mistakes, confidence limits that are not disclosed. Without the knowledge of confidence interval, there is a possibility to face limited interpretation.
• Other differences would occur because of single- way interventions in monetary market, influence on capita movement, export earning for generating national growth, flexibility in currency etc.

Conclusion

After the above discussion, it can be said that ERF models are generally complex to test because of derivations of expectations, directly observing facilities and excessively volatile in the literature that has been accepted. However in implementing such models, some issues should be considered such as Use of multiple models to a certain extent of a single or few ones, light on real effective rather than bilateral ones, emphasize on confidence limit, Search for other versions for the sustainable currency misalignment. However, now-a-days, more energy and capacity are involving in making comparisons to improve ER and model performance are initiating to assist in comprehensive explanations in public and private areas, updated measures and consistent working basis.

Bibliography

Samuelson, P. A., Nordhaus, W. D. (2006), Economics, 18^th Edition, Tata Mcgraw-Hill Publishing Company Limited, New Delhi.

Mcconnel, C. R., Brue, S. L. (2005), Economics-Principles, problems and policies, 16^th Edition, Mcgraw-Hill International Edition, Singapore.

Keat, P. G., Young, P. K. Y (2003), Economics, 4^th Edition, Pearson Education, Inc., Singapore.

Bodie, Z. Kane, A. and Marcus A. J. (2005), Investments, 5th Edition, Tata McGraw-hill publishing company limited, New Delhi.

Engel, C. (2006), Exchange-Rate Models. Web.

Grauwe, P. D., and Verfaille, G. (1988), Misalignment of Exchange Rates, ed. Marston, R. C, University of Chicago Press.