foreign exchange rate forecasting_s.pptx

# In the case of capital budgeting for fdi such as the

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In the case of capital budgeting for FDI, such as the idea of establishing a subsidiary, the decision is normally based on a feasibility study involving the estimation of the expected cash flows of the subsidiary. Exchange rate forecasting is needed in order to convert the estimated cash flows into domestic currency. Financing decision A currency will be chosen for financing purposes if it is expected to depreciate. A long term financing decision involves the choice of the currency to serve as the denomination of a bond issues for example.

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6 Pricing decisions Product price in foreign currency depends on domestic price, and exchange rate for foreign market penetration. Exchange rate forecast is important. Strategic planning Choice of production location and the foreign markets in which to sell the products. International firm incur costs in countries where currencies are expected to depreciate and earn revenue where currencies are expected to appreciate. Exchange rate forecast is important. Macroeconomic conditions Other macroeconomic variables, X, M, GDP growth, budget etc. depend on exchange rate. Their future values will also depend on future values of exchange rate. Exchange rate forecast is important. Central bank Central bank intervenes in the FX market in order to take the expected
7 Econometric forecasting models: Single-equation models These are models that are specified on the basis of economic theory and estimated by an econometric method and are classified into single-equation and multi-equation models For e.g. purchasing power parity theory states that changes in exchange rate are explained by the inflation differentials in the two countries. The econometric model can be stated as , where S is the continuously compounded return on exchange rate, P & P* are the inflation rates in domestic and foreign countries respectively. The inflation differential consists on two observed variable and sometimes it’s referred as a composite variable . The model can be estimated by OLS, and the forecast will be: In general, the exchange rate (or its rate of change) may depend on more than one variable: Forecasts of S depends on forecasts of Xs S & X may be measured in natural logarit

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8 Single equation model is called as a reduced form model because it does not explain how the explanatory variables are determined. We take the explanatory variables as given or assume they are exogenous. Examples of simple single-equation models: Multiple regression model will have more than one explanatory variables. For e.g., exchange rate model with inflation, GDP growth, and interest rates differentials, and forward rates as explanatory variables. Single-equation models
9 Multi-equation econometric models Structural Multi-equation models can take endogeniety in X variables into account. This can be done by specifying equations to explain the explanatory variables X1,…Xn.

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