Forecasting Effectiveness of the Exchange Rate of Euro Finance Essay

The proposed title for this topic analysis is "forecasting effectiveness of the exchange rate of Euro in the conditions of financial crisis".

Introduction and Background:

There has been significant discussion within the financial management literature regarding the forecasting techniques used to analyse future turbulence within the currency exchange rates. This focus, according to Perry (2009) is due to the fact that any such fluctuations have a direct correlation with the profitability of an international firm. Yu et al (2006) has argued that currency fluctuation has increasingly become an important financial management phenomenon due to its direct correlation with the costing and pricing of the products, supplies, and operations of contemporary firms. It has been argued by Buti & van den Noord (2009) that organisations that are only operational within single national economy are also subjected to the turbulence within the "hard" currencies as a number of raw materials and inputs of the value chain of the firm are internationally traded. According to Yu et al (2006), hard currencies are stable economic units that are used as key trading currencies due to their relative reliability and stability over extended periods of time.

Euro has become increasingly important international currency since it was introduced within the EU on 1st January 1999. Drawing upon Emerging Europe Monitor (2009), it can be highlighted after the initial period of turbulence due to the harmonisation of exchange rates across the EU member states; the currency has become highly stable and is therefore become the second largest reserve currency in the world after the US Dollar. The stability of the currency has been recognised from the fact that it is adopted by more than 16 advanced and developed EU member states, which combined makes the second largest economy in the world based on cumulated GDP and purchasing power parity. This proposed research is therefore aimed at forecasting effectiveness of the exchange rate of Euro in the conditions of financial crisis.

Theory and Prior Research:

Foreign exchange forecasting have been found as key mechanism across the markets of the world for a number of decades that challenge the efficient market hypothesis, i.e. currencies are rationally priced and reflect all the available information. Sosvilla-Rivero & García (2005) has provided evidence for return reversal across markets in the long term while analysing the Dollar and Euro exchange rate forecasting. The study has provided empirical evidence by dividing the currencies into winners and losers based on their exchange rate fluctuations in past three years. It was found by the study that losers outperform winners in the five year returns to post-formation of these categories. These findings cannot be explained with rational pricing model, nor can it be explained through weak form of market efficiency. The researchers have explained this change in returns as over reaction of investors to past market and economic information. Dunis & Williams (2002) have also linked market efficiency with the degree of forecasting within exchange rates while studying the momentum effect. The researchers noticed that investors that followed short term strategies of buying performing currencies and selling losing currencies over a three to twelve month time period resulted in significant positive returns over the three to twelve month holding time. It has been suggested by the researchers that this turbulence in prediction represents that buying and selling past winners and losers respectively will lead to the currency exchange to move temporarily away from their real long term value. Later studies have also found similar results and underlying reasons across the capital markets of the world, for example Jamaleh (2002) has studied twelve biggest European stock markets regarding the underlying reasons for momentum effect and signaled towards the weak form of efficiency as the main cause, which has been compared to the exchange rate forecasting by Savchenko & Makar (2010).

There is a school of thought that has related semi-strong form of market efficiency with exchange rate fluctuations and suggested that it is one of the major underlying cause of their presence in today's developed currency markets. The semi-strong market hypothesis, according to Sartore et al (2002), suggests that investors can not earn abnormal risk-adjusted returns using any information and data that is publicly available. The hypothesis has been challenged by a number of studies that have concluded that investors in some particular circumstances have been able to earn extra ordinary profits with the publicly available information. Jose (2001), for example has found through his longitudinal research that average returns of large caps were very low given their market beta values, while on the other end the average returns of small caps were too high. A similar such investigation has been undertaken by Mary (2002), who divided currencies into categories based on market capitalisation and average return over the first year after the formation. The study was used data over the period between 1963 and 1990, and found out that small caps during this time period outperformed the large caps by 0.76% on average return per month. Therefore, it can be suggested that market behaved against the predictions of the capital asset pricing (CAPM) model for currencies, which highlights that high caps earn higher than small caps.

There has also been a discussion in the literature related to underlying reasons for turbulence in exchange rates that have been focused on the effects of economic announcements that also violates the semi-strong market efficiency hypothesis. One of the key studies in the area has been undertaken by Patrick (1998) that divided the currencies into ten different categories based on the change of earning surprise in the most recent economic and interest announcements. The methodology used by the research was to analyse the performance of each category during the sixty days period after the economic policy announcement. The study found out that the category with the highest value for good interest earnings outperform the category with the worst interest earnings announcements by a degree of 4%. Ales & Jaromir (2010) has explained the phenomenon and suggested that currencies with positive earnings announcements have even higher stability in the time period prior to the policy announcement, and at the same time the negative announcements earn relatively higher turbulence. However, in the post announcement period, the currencies with higher earnings surprise also earn significant higher return, which in the case of research of Farhad (2004) is when the categories have been formed. Therefore, it has been suggested by the researcher that there is clear evidence that market under reacts to the new information available and the foreign exchange prices of hard currencies are slowly revised.

The literature has also indicated other variables that have been linked with future foreign exchange performance predictions and forecasts. Drawing upon Andrew (2001), it can be suggested that these variables in currency exchanges are fundamentally scaled by pricing and therefore capital asset pricing model (CAPM) should be used. One of the types of scaled price ratio is the book to market ratio and companies with higher ratios are called value currencies, while with lower values are called growth currencies. According to CAPM, the growth currencies should outperform value growth on the basis of risk differentials attached with each, however the empirical evidence from across the currencies markets of the world negate this explanation. Patrick (1998), for example is one of the key empirical studies using major currencies data. The research divided currencies using the book-to-market ratio and calculated the average return for each category the year after their formation. It was found out by the research that value currencies performed 1.53% better than growth currencies in terms of average monthly returns. Drawing upon Buti & van den Noord (2009), the difference between the between the average return of the value currencies and growth currencies is termed as value premium. This value premium has not been successfully explained with the help of market beta and price-to-earnings ratios.

Research Objectives:

The proposed aim of this research is to critically analyse the effectiveness of forecasting the exchange rate of Euro in the conditions of financial crisis. In order to achieve the proposed aim of this study, the researcher has developed a range of specific research objectives, which have been summarised as follows:

To critically analyse academic point of view surrounding forecasting of exchange rates in turbulent market conditions

To analyse the effectiveness of the popular forecasting techniques that are used within the research to forecast exchange rates of Euro

To highlight key issues that have been found to have implications on the future exchange rate fluctuations of Euro in the context of financial crisis

Methods and Data:

Research methodology, according to Adams & Schvaneveldt (1991) is the key towards highlighting feasibility of the research in the context of wider academic and practitioner environment. It has been argued within the research authenticity and reliability of findings of the research is also highly linked with the robustness of the research methodology and data collection strategy. According to Taylor & Bogdan (1998) methodology in academic research can be seen as the way in which researchers approach the problem and seek its answers. Saunders et al (2003) has highlighted a prescriptive framework that can be used to achieve a robust methodology, which is referred to as "research onion" as decision at each ring has implications on the inner sections. The research onion would therefore be used to achieve the aim and objectives set out for this report and have been illustrated as follows.

Methods:

The research philosophy that underpins this proposed topic is "positivism", which is an epistemological setting that has been used to reach definitive conclusion through positive verification (Saunders et el, 2003). The topic of exchange rate forecasting can be seen to have high degree of objectivity attached to it, which would require conclusive empirical evidence to be proven to hold or not to hold in the context of contemporary financial crisis. This is the reason that the research has found deduction to be aligned towards achieving the aim and objectives of this proposed research. The selection of epistemological philosophy and research approach for this proposed research has their implications on data collection strategy, which has been explained in the following sub-section.

Data:

The researcher proposes multiple method research methods, which would help in achieving triangulation of data (Saunders et al, 2003) and the diverse range of research objectives of this proposed study (Taylor & Bogdan, 1998). These methods include the following:

Secondary Quantitative Research: The secondary quantitative data surrounding historical Euro exchange rate data would be collected along with the key macro, micro and meso business environment changes that have impacted on the turbulence and fluctuations within the exchange rate data. Drawing upon Adams & Schvaneveldt (1991), secondary data collection can help in acquiring audited data that has already been checked for its internal consistency, therefore reducing overall time and resource allocation. It has been argued by Saunders et al (2003) that secondary data provides the advantage of collecting both longitudinal and cross sectional data, which is the requirement of this proposed research, where forecasting and exchange rate data surrounding Euro would be required in both traditional and contemporary sense for the purpose of comparison.

Semi-Structured Interviews: The primary data surrounding the effectiveness of different forecasting methods used for Euro exchange rate will be achieved through semi-structured interviews with forex traders. According to Taylor & Bogdan (1998), this data source can help achieve significant insight into the topic under analysis and can therefore help recommend changes to the current forecasting techniques. The sampling technique that would be used to select forex traders to comment on forecasting effectiveness of the exchange rate of Euro in the contemporary financial crisis conditions would be random sampling. Saunders et al (2003) has argued that using semi-structured interviews provides high degree of control to the researcher in terms of focusing key areas that require further elaboration and discussion.

Research Ethics:

Ethics within the context of academic research has been highlighted by Wells (1994) as the code of behaviour that can be seen as appropriate and acceptable by other academics and practitioners within the field. It can therefore be argued that the definition is broad and subjective, however there are prescribed codes of conduct and ethics highlighted by a number of market research institutions and associations. It should be noted that the only ethical exposure of the current research is associated with the primary data collection, where semi-structured interviews would be collected. Drawing upon Saunders et al (2003), the researcher would therefore develop an informed consent with the interviewees to include any information provided by them into the analysis and final report. In order to streamline the ethical implications of this proposed study, the researcher would therefore use the guidelines of market research given by the renowned MRS association. The use of such ethical underpinnings would help this proposed research, its key findings report and further recommendations to be free from any ethical issue.

Time Scale and Resources:

It should be noted that the current proposed research is bound by limited time period and resources. The allocation of time and resources has therefore been analysed to highlight the feasibility of this research. Drawing upon Robsons (2002), the research should have low levels of risks in terms of researcher's access to the resources required for the research. The key resources required for this research include access to academic literature and secondary traditional data surrounding Euro, which has been negotiated through ATHENS account from university library. The limited time has also been allocated to key aspects of the research and the division of time and labour has been highlighted with the help of the following Gantt chart. In the light of recommendations by Taylor & Bogdan (1998), the researcher would use Microsoft Project to keep track of the progress and milestones surrounding the research.

 

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