Abstract:
The object of this study is to critically appraise the fundamental models, technical
methods and statistical techniques that constitute the bulk of exchange rate forecasting
methodology. Specifically, can any single approach, or combination of techniques,
predict or explain the volatile currency movements characterising exchange rate
behaviour in the modern international currency market?
International currency markets are indeed complex in nature, and the layperson may be
excused for not grasping the distinction between the fundamental, technical and
statistical techniques described in the hypothesis. It is vital, however, for the
comprehension of this study that the distinction between these approaches be
explained, and the logic underlying their individual methodologies examined. It may
prima facie seem that this study is based on a contradiction. Surely if one wants to
predict an economic variable of any kind, one should refer to the economic theory
upon which it is based as the starting point of an analysis. Consequently, if the
objective is to forecast the future value of a currency, surely there are a great many
economic texts that deal with this very question in voluminous detail. Why, then,
should yet another paper be written when so much literature already exists?
The answer lies not so much in the scope as in the purpose of this work. The aim of
this study can be paraphrased. as follows: to provide a comprehensive and critical
examination of the various methods of exchange rate forecasting and to explain why
economic theory is still deficient in this important area. The question of whether or not
short-term' exchange rates are able to be forecast at all will also be critically examined.
This study will attempt to elucidate that while fundamental currency speculation
models do provide a certain degree of guidance to currency-traders in their daily
prognostications, these models are, in the context of modern capital markets,
inadequate. At best, these models will be shown as trackers of long-term exchange rate
trends, and not always accurate ones at that. Further, it will be demonstrated that the
modern trading floors are characterised (if not defined) by split-second price changes,
where the long-term'' can mean a minute, and he who hesitates is lost. It is in this
setting that traders must do battle for profit, and where the fundamental models that
seem to serve so well in textbooks are anachronisms.
The study then shifts its focus to a subset of technical analysis known as charting, the
objective being to fill the void which arises due to the fundamental models'
inadequacies in the short-term. The charting techniques utilised in this study deviate
from their fundamental counterparts in that they attempt to explain future exchangerate
trends in terms of past performance. That is, exogenous changes are factored out
of the forecasting equation, to give way to a methodology based on trendextrapolation.
The performance of these models, especially as they pertain to the
medium- and short-term., will then be determined.
Finally, in an attempt to supplement the use of charts as a forecasting tool, statistical
analysis will be considered. The model utilised in this section will be a rudimentary
auto-regressive process. Its simplicity, however, belies its consequence. That is,
considering that no ubiquitous statistical model dominates exchange rate theory, it is
reasonable to assume that an auto-regressive process, such as the one contributed by
this study, will not be subordinate to other, more complex, quantitative offerings. Thus
this study attempts to provide the necessary insights in order to perspicaciously
1 It should be noted here that the terms "short-term" and "short run" are interchangeable. For the
purposes of consistency, only the former term shall be employed throughout this study.
2 The terms "long-term" and "long run" are also interchangeable. For the purposes of consistency,
only the former term shall be employed throughout this study.
ascertain the proficiency of statistical analysis as an accurate forecaster of exchange
rate fluctuations.
All of the models and methods examined in this study adopt a pragmatic acid-test. That
is to say, if the predictions made as a result of adherence to the models do not comply
accurately and consistently with real findings, then the models themselves should be
revised. This revision can be in terms of the time-frame to which the model pertains,
the application of the model, or the model itself. It must, however, be stressed that a
model whose very raison d'etre lies in its ability to predict exchange rate movements
must be able to do so without qualifications or exceptions. The methodology adopted
in analysing the models themselves is therefore positive as opposed to normative.
Thus, even in the "organised chaos" of the modern exchange rate markets, the
application of the models should yield satisfactory results. In other words, despite the
unprecedented volumes, speed and volatility of the currencies that are traded in the
modern arena, the models themselves should still be able to achieve their purpose - to
forecast the extent and direction of changes in the par value of a currency. The next
logical question is: what is meant by the "organised chaos", and specifically why
should this influence the predictive ability of the fundamental, technical and statistical
methods of exchange rate forecasting?
The answer to this can be introduced as follows. On an almost daily basis, currency
traders move an excess of one trillion dollars throughout the world. Adding to the
gravity of this somewhat overwhelming statistic is that most of these are intercomputer
transactions occurring instantaneously via inter-bank wire-transfers. In fact,
the volume of currency traded is so great that if one were to sum the trading of all the
Saudi oil, American wheat, European aircraft and Japanese cars, the monetary result
would seem pithy in comparison (Millman, 1995:xxi).
It is, however, not only the sheer volumes of currencies traded that characterise the
international money markets. It is perhaps more importantly the unanticipated and
unparalleled volatility of the markets themselves which provides the greatest quandary
for those who conform to 'traditional' methods of exchange rate determination. It is all
too common, in fact, for currency prices to change on a minute-to-minute or even
second-to-second basis. Exchange rates are thus in a constant state of flux. The
significant though infrequent changes of past years have been terminally disposed of.
The inception of the microcomputer and the floating exchange rate system currently
dominating the greater world economy has irrevocably altered what was considered a
flawed order. It is this very metamorphosis which will be examined in detail,
specifically how fundamental models have assumed a differing purpose to those used
by modern speculators, hedgers and arbitrageurs in their specific fields of application.
Thus it will be shown how the changing paradigm of the world economy and
consequently the currency trading floors themselves necessitate neoteric predictive
powers, that is, the power to forecast currency changes not in terms of years, months
or even weeks, but rather in terms of days, minutes and seconds. The object of this
thesis will therefore be to show that a definite dichotomy has developed between the
exchange rate models espoused in economic textbooks and the techniques upon which
the de facto day-to-day buying and selling of currencies depend. The efficacy of this
study consequently hinges on one decisive question - is there truly a consistent and
precise method of forecasting exchange rates?