Exchange Rate Forecasting (Thesis Proposal Sample)

Exchange Rates Forecasting
Student’s Name
University Affiliation
Introduction
The research interests cover the area of International Macroeconomics. The research will focus on models of forecasting euro exchange rates against the dollar. This research is important because financial markets are facing volatile and unpredictable exchange rate and macroeconomic fundamentals. Therefore, it is imperative to bring these issues to light. There has been an effort of finding an equilibrium exchange rate because it affects country’s economy competitiveness. An overvalued exchange rate results in uncompetitive domestic goods, which make the economy, face competitive problems. Indeed, undervaluing the exchange rate makes the economy face inflationary pressures because increased price of imported goods raises the consumer price index. Besides, finding a fixed model that can be used to forecast exchange rate especially in short horizons has remained a hard task to the economics. According to Ince and Trafalis (2006), several types of forecasting models have been used in an attempt to forecast euro exchange rates against the dollar. Therefore, the major models, which will be discussed in the paper PPP, UIRP, and International Fisher Effect, BOP, and VAR model. In this study, the finalized model will be computed through a Monte Carlo Simulation using Excel Visual Basic programming tools to forecast euro rates. In this context, the current paper will investigate the most effective exchange rate forecasting model applicable to most world currencies in short, medium and long run and conditions.
Purpose
This study analyzes different models and economic theory and attempts to provide insight to the understanding of how to forecast euro exchange rates against the dollar. The paper also aims to establish an estimating model, which applies to a variety of currencies across different conditions and time.
Significance of Study
Exchange rate predictions are vital inputs for all business decisions, particularly for multinational businesses. Besides, the oversea exchange market investors require exchnage rate predictions for correct decisions concerning investments and speculation. Therefore, this study will assist America, as well as, foreign banks, individuals, companies, foreign currency traders, as well as, investment management organizations to forecast the rate of exchnage through using correct forecasting model.
Study Organization
Remaining parts of the research continues as follows, comprehensive literature about forecasting models are examined in the literature review section. This section also examines the theoretical framework of the study. The methodology section outlines the data collection and analysis, the researcher will employ. The section also examines the variables for the research. The study ends with the conclusion, which provides a synopsis of the study.
Literature Review
Fundamental Analysis
In their study, Frenkel (1978) pointed out that the fundamental model has some limitations such as liquidity constraints, ignoring the cost of the transaction, as well as, transportation cost. Normally, the fundamental models of exchange rate include the interest rate parity, PPP (Purchasing Power Parity), MM (Monetary Model), BOP (Balance of Payment) among others. Therefore, this section discusses the fundamental models for estimating exchange rates and provides a theoretical framework of the same.
Relative Purchasing Power Parity (PPP)
The PPP hypothesis has been used since the years after World War 1 as a theory of determining the exchange rate in long run conditions. The Relative PPP hypothesis states that the exchange rates and price ratio must change proportionally. However, no empirical study shows evidence that exchange rate movements and price level shifts are proportional. Empirical studies show that PPP tends to hold in the medium- long run, but not in the short run. The explanation is that the economic forces tend to eliminate differences in PPP across different countries. The short-term deviations from equilibrium in the short-run can be explained as follows. First, the PPP is based on international goods arbitrage, which can be eliminated by trade costs. Secondly, the international arbitrage opportunities should be constructed on the fact that good is internationally tradable- not all goods have this feature. Thirdly, the international arbitrage is based on similar basket of goods.
Frenkel (1978) found PPP as an appropriate situation for any exchange rate determination model in a number of hyperinflationary countries. However, the model does not hold if hyperinflation is not the case. The empirical evidence implies that the monetary models can not be applied successfully in explaining both short run and adjustment of the exchange rate. The above limitation calls for a study of alternative approaches of explaining the exchange rate behavior.
Uncovered Interest rate parity
There are covered interest rate parity and uncovered interest rate parity. In the theory of the Covered interest rate parity, the difference between the interest rates for two countries equals to the difference between their forward exchange rates and the spot exchange rates. The uncovered interest rate difference never utilizes forward rates of exchange; however; it uses the anticipated fluctuations in spot rates. If the difference in two interest rates is higher than expected change in spot rates, there is a potential profit. Uncovered interest rate parity does not exist when the difference between expected and current foreign exchange rates are 1: 1. However, when it exists investors may take that arbitrage opportunity and increase in supply and demand.
The exchange rate behavior can be explained by the use of Natural Equilibrium Exchange Rate (NATREX). The NATREX approach’s objectives include explanation of volatility of exchange rate and the effects of changes in specific fundamentals. The approach involves a stock-flow dynamic model in which the difference between the long-term and medium-term exchange rate adjustments. In the end, the stock of debt and the output level are endogenous to the system, but in the medium-term, they are exogenous. Based on explicit fundamentals and endogenous changes in debt and capital, the NATREX is a moving-equilibrium PPP. The approach indicates that the real exchange rate is going to appreciate in the medium-run and to depreciate in the end.
The Fundamental Equilibrium Exchange Rate (FEER) presented by Williamson in 1985 is one of them. The approach FEER is also referred to as "macroeconomic balance approach" because of its ability to approximate the exchange rate in uniformity with the macroeconomic balance. FEER can be explained as the equilibrium rate that would be steady with the ideal macroeconomic performance. When the price level and employment met their target level, the internal balance condition is satisfied. Williamson’s model interpretation of external balance differs with the traditional interpretation. Williamson’s take the external balance condition in terms of current account balance; it must be sustainable. Traditional interpretation external balance exist capital flow finance the current account imbalances leaving reserves unchanged. The Behavioral Equilibrium Exchange Rate (BEER) is another alternative method that can be used to explain exchange rate behavior. The BEER approach estimates the misalignments of exchange rates in agreement with the variations between the real exchange rate and the estimated value drawn from the connection between the actual rate of exchange and the macroeconomic fundamentals.
There exist numerous studies, which attempt to forecast the exchange rates and to define the long-term relationship between exchange rates and their fundamentals. FEER and BEER are the most used methods in United States, Japan, Germany, and some small developing countries (Clark & MacDonald, 1999). In the recent years, there ha been an increased interest in the study of Euro. The following are some of those studies in exchange rates.
Feyzioglu (1997) studied Finnish markka for a period of 20 years (1975 – 1995) to estimate the equilibrium real effective exchange rate. His design was similar to FEER with the long-term equilibrium exchange rate described as the level dependable with concurrent internal and external balance. Using the Johansen co-integration technique, he estimates a reduce form model. His theoretical model indicates that a positive term of trade shock appreciates the real effective exchange rate. If the world interest rate increases, the domestic interest rate increases resulting to appreciation of the exchange rate and reduced demand for money. The result is an increase in savings and improvement in the external position of the economy. The author also observes that a positive productivity differential appreciates Finnish markka. The results of estimating the econometric model by the Full Maximum Likelihood method means that all coefficients have the anticipated signs. Modeling short run movement by an Error Correction Model indicates that a higher foreign interest rate and higher domestic price level appreciate the real effective exchange rate. The author concludes that the real exchange rate diverges from its long run equilibrium rate.
MacDonald (2002) estimated the equilibrium exchange rate for the New Zealand Dollar for 15 years (1985-2000) using the BEER approach. Inspired by UIP condition, his theoretical model indicates that the present equilibrium exchange rate is obtained by the interest rate differential plus a systematic component. The systematic component is obtained from the ratio of net foreign assets to GDP, relative output gap, relative labor productivity, and terms of trade of New Zealand. The author estimates the m...