1. FOREIGN EXCHANGE RISK MGMT.
On analysis, at least two fundamental exchange
risk management strategies can be distinguished
which is called “Aggressive” and “Defensive”.
Whether to follow an aggressive policy or to
pursue a defensive policy would actually depend
on the foreign exchange rate projections and the
ability of the company to beat the forward rates.

2. NEED FOR FOREIGN EXCHANGE
RATE PROJECTIONS
The decision making process in the MNC’s are
very much dependant on exchange rate
projections.
•Hedging decision : MNC’s are constantly
confronted with the decision of whether to hedge
future payables and receivables in foreign
countries. Now, whether the firm should hedge or
not is dependant on its forecasts of foreign
currency values. As for example ---------

3. NEED FOR FOREIGN EXCHANGE
RATE PROJECTIONS
Consider a firm in US that plans to pay for Gems
imported from India in 90 days. If the forecasted
value of Indian rupee in 90 days is sufficiently
below the 90 day forward rate, the MNC may
decide not to hedge.
Short term financing decision : When large
corporations borrow they generally have access to
several different currencies. The currency in which
they borrow ideally has two features, namely ……

4. NEED FOR FOREIGN EXCHANGE
RATE PROJECTIONS
It will exhibit a low interest rate.
It will weaken in value over the financing period
(observation on an average basis globally).
Now, suppose an Indian firm borrows US dollars
and then converts it into rupees. If the dollar
depreciates as per the above theory, the Indian
firms will have to pay back less amount than
earlier. Hence, it is important for the multinational
companies to have access to proper forex rate
projections.

5. NEED FOR FOREIGN EXCHANGE
RATE PROJECTIONS
Short term investment decision : Corporations
sometimes have substantial amount of excess
cash available for a short term. They also have the
access to create investments in several currencies.
In contrast to borrowing, the ideal currency would
(a) exihibit high interest rates and (b) would
strengthen in value over the investment period.
Hence, here also the forex rate projections would
be necessary to select the ideal currency for
investment purpose.

6. NEED FOR FOREIGN EXCHANGE
RATE PROJECTIONS
Capital budgeting decision: When an MNC attempts
to determine whether or not to establish a
subsidiary in a foreign country, they do resort to
some sort of capital budgeting.
Forecasts of the future cash flows will definitely be
dependant on future exchange rates and currency
values. Hence, in order to have a realistic
assessment of future cash flows for the purpose of
capital budgeting , the forecast of forex rates need
to be good.

7. NEED FOR FOREIGN EXCHANGE
RATE PROJECTIONS
Long term financing decision: MNC’s may at
times issue bonds to raise funds in foreign
currencies. In order to estimate the cost of
issuing bonds denominated in a foreign currency,
forecasts of exchange rate are required.

8. FORECASTING TECHNIQUES
Technical forecasting : Technical forecasting of
exchange rates is at times, similar to technical
forecasting of stock prices. Such type of forecasting
is not supposed to hold good, when the currency
values do not follow a trend line and appears to be
random.
Technical forecasting models have at times proved
themselves BUT a model that has worked well in
one particular period may not necessarily do justice
in another period.

9. Technical forecasting
With the abundance of technical forecasting models
that exist today, some are bound to generate profits
and prove themselves, while most of them actually
fail.
Some of the participants even say that once a
technical forecasting model is used by a large
number of other participants, it ceases to remain
useful. This is because of the fact that trading based
on the recommendations of the model pushes the
currency value to a new position, where a separate
strategy is required.

10. Technical forecasting
From the corporate point of view, use of
technical forecasting is very much limited, as
because it always focuses on the near
future, which is not that helpful for developing
corporate policy.
In totality, technical forecasting methods are
rarely used by the MNC’s because of their
unsuitability.

11. Fundamental forecasting
Such kind of forecasting is based on fundamental
relationships between economic variables and the
exchange rates.
For example : High inflation in a given country can
lead to depreciation in the home currency. Many
other factors may also influence the exchange rates.
The forecast may be based on, simply a subjective
assessment of the degree of movement in the
economic variables and their corresponding effect
on the exchange rates.

12. Fundamental forecasting
Consider for an example that a firm’s objective is
to forecast the percentage change in the Indian
rupee with respect to US Dollar, during the next
quarter.
The forecast may be dependant on many
factors, however the major factors could be :
A) Inflation in US relative to inflation in India.
B) Income growth rate in US relative to income
growth rate in India.

13. Fundamental forecasting
Taking into consideration the two factors a
regression analysis is conducted, and an equation is
developed, based on previous historical data of both
the countries.
The following type of conclusions could be derived
by such regression analysis.
a) For one unit percentage change in inflation
differential, the rupee is expected to change by 00 %
in the same direction, other things remaining
constant.

14. Fundamental forecasting
b) For one unit percentage change in income
differential, the rupee is expected to change by 00 %
in the same direction , other things remaining
constant.
C) Given the current figures of inflation rates and
growth in income, the rupee should appreciate or
depreciate by 00% in the next quarter.
A full blown model of fundamental forecasting may
consider more than two variables, yet the
application would be somewhat similar.

15. Fundamental forecasting
Use of PPP for fundamental forecasting : PPP
specifies the fundamental relationship between
the inflation differential and the exchange rate.
PPP states that the currency of a relatively
inflated country will depreciate by an amount
that reflects the country’s inflation differential.
If this theory would be accurate in reality, there
would not be a need to consider any other
alternative forecasting technique.

16. Fundamental forecasting
However, using the inflation differential of two
countries, to forecast their exchange rate will not
always hold good, because of the following
reasons :
a) The timing of the major impact of inflation and
the timing of corresponding impact on exchange
rates is never known with certainty.
b) Data used to measure the relative inflations in
the two countries may not be accurate or similar.

17. Fundamental forecasting
c) Barriers to trade can disrupt the trade patterns
that should emerge in accordance with PPP
theory.
d) Other factors such as interest rates in the two
countries may also affect the exchange rates.

18. Market based forecasting
This is a process of forecasting, developed from
market indicators viz. THE SPOT RATE AND THE
FORWARD RATE.
Assume that the British Pound is expected to
appreciate against the Rupee in the near future.
This will encourage the speculators to buy the
Pound with Rupee today, in anticipation of gain.
Conversely, if the Pound is expected to
depreciate against the Rupee, speculators will
tend to sell of the Pounds now.

19. Market based forecasting
Such actions of the speculators, would in fact
force the currencies to depreciate or appreciate
in the near future.
Thus the corporations, can use the spot rates to
forecast the spot rates of the near future.

20. Market based forecasting
Assume that the forward rate of British pound is
Rs.70/- and the general expectation of
speculators is that the spot rate of pound will be
73/- , at the end of the forward period. Such a
situation will drive the speculators to buy pounds
in the forward market at 70/-, just to gain 3/- at
the end of the forward period. Such general
drives in the market may cause the forward rate
to increase, until this speculative demand ceases.
Possible forward rate may rise to 73/- thus
driving away any profit due.

21. Market based forecasting
Thus, the general craze of the market regarding
the forward rates and the following outcomes,
can also help the firms to forecast the future
movements in the exchange rates.