Reference no: EM132952510

Forecasting Exchange Rates

• Recall that Blades, Inc., the U.S.-based manufacturer of roller blades, is currently both exporting to and import- ing from Thailand. Ben Holt, Blades' chief financial officer (CFO), and you, a financial analyst at Blades, Inc., are reasonably happy with Blades' current perfor- mance in Thailand. Entertainment Products, Inc., a Thai retailer for sporting goods, has committed itself to purchase a minimum number of Blades' Speedos annually. The agreement will terminate after 3 years. Blades also imports certain components needed to manufacture its products from Thailand. Both Blades' imports and exports are denominated in Thai baht. Because of these arrangements, Blades generates approximately 10 percent of its revenue and 4 percent of its cost of goods sold in Thailand.
• Currently, Blades' only business in Thailand consists of this export and import trade. Holt, however, is think- ing about using Thailand to augment Blades' U.S. business in other ways as well in the future. For example, Holt is contemplating establishing a subsidiary in Thai- land to increase the percentage of Blades' sales to that country. Furthermore, by establishing a subsidiary in Thailand, Blades will have access to Thailand's money and capital markets. For instance, Blades could instruct its Thai subsidiary to invest excess funds or to satisfy its short-term needs for funds in the Thai money market. Furthermore, part of the subsidiary's financing could be obtained by utilizing investment banks in Thailand.
• Due to Blades' current arrangements and future plans, Holt is concerned about recent developments in Thailand and their potential impact on the com- pany's future in that country. Economic conditions in Thailand have been unfavorable recently. Movements in the value of the baht have been highly volatile, and foreign investors in Thailand have lost confidence in the baht, causing massive capital outflows from Thai- land. Consequently, the baht has been depreciating.
• When Thailand was experiencing a high economic growth rate, few analysts anticipated an economic downturn. Consequently, Holt never found it neces- sary to forecast economic conditions in Thailand even though Blades was doing business there. Now, however, his attitude has changed. A continuation of the unfavorable economic conditions prevailing in Thailand could affect the demand for Blades' pro- ducts in that country. Consequently, Entertainment Products may not renew its commitment for another 3 years.
• Since Blades generates net cash inflows denomi- nated in baht, a continued depreciation of the baht could adversely affect Blades, as these net inflows would be converted into fewer dollars. Thus, Blades is also considering hedging its baht-denominated inflows. Because of these concerns, Holt has decided to reas- sess the importance of forecasting the baht-dollar exchange rate. His primary objective is to forecast the baht-dollar exchange rate for the next quarter. A sec- ondary objective is to determine which forecasting technique is the most accurate and should be used in future periods. To accomplish this, he has asked you, as the financial analyst at Blades, for help in forecasting the baht-dollar exchange rate for the next quarter.
• Holt is aware of the forecasting techniques available. He has collected some economic data and conducted a preliminary analysis for you to use in your analysis. For example, he has conducted a time-series analysis for the exchange rates over numerous quarters. He then used this analysis to forecast the baht's value next quar- ter. The technical forecast indicates a depreciation of the baht by 6 percent over the next quarter from the baht's current level of $.023 to $.02162. He has also conducted a fundamental forecast of the baht-dollar exchange rate using historical inflation and interest rate data. The fundamental forecast, however, depends on what happens to Thai interest rates during the next quarter and therefore reflects a probability distribution. Based on the inflation and interest rates, there is a 30 percent chance that the baht will depreciate by 2 per- cent, a 15 percent chance that the baht will depreciate by 5 percent, and a 55 percent chance that the baht will depreciate by 10 percent.

Holt has asked you to answer the following questions:

Problem 1. Considering both Blades' current practices and future plans, how can it benefit from forecasting the baht-dollar exchange rate?

Problem 2. Which forecasting technique (i.e., technical, fundamental, or market-based) would be easiest to use in forecasting the future value of the baht? Why?

Problem 3. Blades is considering using either current spot rates or available forward rates to forecast the future value of the baht. Available forward rates currently exhibit a large discount. Do you think the spot or the forward rate will yield a better market-based forecast? Why?

Problem 4. The current 90-day forward rate for the baht is $.021. By what percentage is the baht expected to change over the next quarter according to a market- based forecast using the forward rate? What will be the value of the baht in 90 days according to this forecast?

Problem 5. Assume that the technical forecast has been more accurate than the market-based forecast in recent weeks. What does this indicate about market efficiency for the baht-dollar exchange rate? Do you think this means that technical analysis will always be superior to other forecasting techniques in the future? Why or why not?

Problem 6. What is the expected value of the percentage change in the value of the baht during the next quarter based on the fundamental forecast? What is the forecasted value of the baht using the expected value as the forecast? If the value of the baht 90 days from now turns out to be $.022, which forecasting technique is the most accurate? (Use the absolute forecast error as a percentage of the realized value to answer the last part of this question.)

Problem 7. Do you think the technique you have identified in question 6 will always be the most accurate? Why or why not?