A key aspect of corporate pricing strategy is forecasting future exchange rates. Aside from using banks to help them do this, the internal models corporations use are typically one or more of the following kinds:
Political event analysis
Fundamental
Technical
For the reasons we have mentioned earlier in this blog, it is not a good idea for corporations to use the forward rate as a predictor of the future spot rate because of “forward rate bias” — the idea that the unbiased forward rate theory does not in fact work. Academics argue that markets are efficient and therefore there is no point in corporations trying to “beat the market” by forecasting future exchange rates. This supposition is premised on a falsehood — markets may be efficient over the long term, but they are inherently inefficient over short time periods. The latter can be substantial enough to make a material impact on the corporation’s income statement were it to assume a perfectly efficient market and use unbiased forward rate theory accordingly.
The importance of market-based forecasts for the corporation is derived from comparing these to anticipated net cash flows. For the corporation, the crucial question is how will these cash flows respond if the future spot exchange rate is not equal to the forecast? The nature of this kind of forecast is completely different from trying to outguess the foreign exchange markets.