Question

Pick one of the following:
•   Technical Forecasting
•   Fundamental Forecasting
•   Market Based Forecasting

Why might forecasting be used by a multinational corporation?

Clearly define the forecasting technique you have chosen. Explain in detail what is involved with the forecasting technique you have chosen.

Explain what is meant by market efficiency. Then explain the implications of market efficiency on your chosen technique.

Answer 1

I have picked up fundamental forecasting.

Why might forecasting be used by a multinational corporation?

An MNC deals with businesses in multiple currencies. It's operations, profitability and cash flows are dependent upon exchange rates. It therefore requires an estimate of forecast for exchange rates in advance to make various strategic and operational decisions. An MNC will therefore require exchange forecasts for:

• Figuring out their exposures in different currencies and thus determine hedging decisions
• Assessment of profitability and cash flows in the next forecast period
• Assessment of surplus or shortfall in the cash flows and:
  • Decide upon short term investment decisions in case there is surplus
  • Look for bridge financing decisions in case there is shortfall
• Assessment of undertaking capital expenditures in the next forecast period
• Deciding upon various financing decisions in the long run

Clearly define the forecasting technique you have chosen. Explain in detail what is involved with the forecasting technique you have chosen.

Fundamental forecasting technique attempts to forecast exchange rates based on the interplay of fundamental factors of economy like interest rate, inflation, purchasing power parity, capital inflows and outflows. It attempts to derive a relationship between these variables and exchange rate and then tries to forecast the exchange rate for the next forecast period based on those relationships.

Such a forecasting technique will involve:

• Subjective assessment of fundamental factors and their impact on exchange rate
• Objective and quantitative assessment of fundamental factors and their impact on exchange rates
  • Typically used quantitative tools are regression analysis, sensitivity analysis, regression equations, empirical relationships etc.

A fundamental forecasting techniques like any other forecasting technique will have certain limitations:

• May not be able to capture all the variables
• Response of the model may be delayed while impact in real life may be immediate or even instantaneous - the forecasting model may require longer time to predict
• Linkages between the variable may not be established strongly
• Uncertainties associated with the factors might not have been captured strongly
• Trade barriers, protectionism by the government etc may impact the real life but model may not be able to incorporate the same

Explain what is meant by market efficiency. Then explain the implications of market efficiency on your chosen technique.

Market efficiency measures how quickly and strongly market absorbs historical and recent, public and private information and started behaving accordingly. If we are in strong form of market efficiency, the market would have already absorbed all the historical & recent, private and public information and in that case current exchange rate is the best forecast for future.

If we are in semi strong form of market efficiency, the market is expected to have absorbed all the information in public domain and hence current exchange rate would be semi strong predictor of future exchange rate.

In the weak form, the market is expected to have absorbed only the public historical information. In that case any technical analysis based on historical data would not yield any new beneficial result.

Exchange rate market is semi strong. Hence, public information is fully absorbed by the market and the exchange rate forecasted by our chosen technique (fundamental technique) would be semi strong. It wil have margins of errors and limitations. It will not yield a perfect estimate however it's forecast will be reasonable.

Such a forecast may not simplify all the problems of an MNC but they can definitely make their lives simpler:

• MNC can still reasonably assess its profitability, cash flows position
• An MNC can by and large know the range of foreign currency exposure (not the exact value) and hence deicde upon a suitable hedging plan
• An MNC can take a call on volatility in the exchange rate market. It can take scientifically driven decisions which may or may not always be accurate.