220 Module 8 The International Monetary System and Financial Forces baskets. This relationship is expressed in the following equation, where P is the price of a basket of commodity goods: £P($/£) = $P For example, if a basket of goods costs $1,500 in the United States and £1,000 in the United Kingdom, the PPP exchange rate will be $1.50/£. If, in the trading market, the actual spot exchange rate were $2/£, the pound would be overvalued by 33 percent, or, equivalently, the dollar undervalued by 25 percent. The Economist, a British weekly magazine, presents an application of PPP theory in its “Big Mac index,” substituting an omnipresent Big Mac for a basket of goods. The Big Mac PPP is the exchange rate that would have a Big Mac in other countries costing an amount equivalent to what it does in the United States. The Big Mac index suggests that in the long term, many of the developing countries’ currencies are undervalued and the euro and many European currencies are overvalued. You can check the latest Big Mac index and view a video explaining The Economist’s efforts to make economics as simple as it ought to be at http://www.economist.com/content/big-mac-index/. EXCHANGE RATE FORECASTING Because exchange rate movements are so important to all aspects of international business— production, sourcing, marketing, and finance—many business decisions take the risk of exchange rate movement into consideration through forecasts. There are several approaches to forecasting, and three of the main ones are the efficient market approach, the fundamental approach, and technical analysis. We briefly examine each. The efficient market approach assumes that current prices fully reflect all available relevant information. This assumption also suggests that forward exchange rates are the best possible predictor of future spot rates, because they will have taken into account all the available information. For example, if interest rates are different between two countries, the forward rate will reflect this (per the international Fisher effect). The efficient market approach does not suggest the forward rate will predict the future spot rate with perfect accuracy, though. Rather, any divergence will be random. A forecasting theory related to the efficient market approach is the random walk hypothesis, which holds that because the factors that influence prices are unpredictable, stock market prices evolve much like a random walk, turning here and there without a controlling logic, so that the best predictor of tomorrow’s prices is today’s prices.18 Burton Makiel, an economics professor at Princeton, popularized this observation in his 1973 book A Random Walk Down Wall Street. The fundamental approach to exchange rate prediction looks at the underlying forces that help determine exchange rates and develops various econometric models to capture them and their correct relationships. The international finance scholars Cheol Eun and Bruce Resnick have surveyed the research on the various fundamental models and conclude that “the fundamental models failed to more accurately forecast exchange rates than either the forward rate model, which we have termed the efficient market model, or the random walk model.”19 The third approach to exchange rate forecasting, technical analysis, looks at history and then, assuming that what was past will be future, projects these trends forward. Technical analysts think in terms of waves and trends. There is no theoretical underpinning to the technical approach, and while academic studies tend to dismiss it, it appears that traders often use it. As for the performance of these forecasting approaches, research by Eun and Sabherwal concludes that the 10 commercial banks in their study could not outperform the random walk model.20 Their findings also suggest that the forward exchange rate and the spot rate were both about equal in value for predicting future exchange rates. Neither the technical nor the fundamental approach appears to outperform the efficient market approach. Additional research suggests that combining forecasts generated by these and additional models may be helpful. We have examined a major financial force that international managers have to address— foreign exchange fluctuations, their causes, and their prediction. We now look efficient market approach Assumption that current market prices fully reflect all available relevant information random walk hypothesis Assumption that the unpredictability of factors suggests that the best predictor of tomorrow’s prices is today’s prices fundamental approach Exchange rate prediction based on econometric models that attempt to capture the variables and their correct relationships technical analysis An approach that analyzes data for trends and then projects these trends forward
Geringer_InternationalBusiness
To see the actual publication please follow the link above