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How can you forecast foreign exchange risk?

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Foreign exchange risk, also known as currency risk, is the potential loss or gain from fluctuations in exchange rates between different currencies. If your business operates in multiple markets or deals with foreign suppliers or customers, you need to forecast foreign exchange risk to manage your cash flow, profitability, and competitiveness. In this article, you will learn how to forecast foreign exchange risk using four steps: identifying your exposure, choosing a forecasting method, applying a forecasting model, and evaluating your results.

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Vikesh Kumar, MBA

Ph.D. Candidate (ABD)
Ahmed Elashkar CPA, CIA, CVA, CertIFR

Sr. M&A advisor, add value to firms via maximizing Shareholders’ value.

1 Identify your exposure

The first step to forecast foreign exchange risk is to identify your exposure, which is the amount and type of currency risk you face. You can categorize your exposure into three types: transaction exposure, translation exposure, and economic exposure. Transaction exposure is the risk from changes in exchange rates affecting the value of your current or future contracts, invoices, or payments. Translation exposure is the risk from changes in exchange rates affecting the value of your foreign assets, liabilities, or income statements. Economic exposure is the risk from changes in exchange rates affecting your long-term competitiveness, market share, or profitability. You can use financial statements, budgets, forecasts, and market research to assess your exposure for each type and currency.

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2 Choose a forecasting method

The second step to forecast foreign exchange risk is to choose a forecasting method, which is the approach you use to predict future exchange rates. You can choose between two main methods: fundamental analysis and technical analysis. Fundamental analysis is based on the economic and political factors that affect the supply and demand of currencies, such as inflation, interest rates, trade balance, and government policies. Technical analysis is based on the historical patterns and trends of exchange rates, such as price movements, volume, and indicators. You can use both methods to complement each other and improve your accuracy, or you can focus on one method depending on your preference, data availability, and time horizon.

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Ahmed Elashkar CPA, CIA, CVA, CertIFR

Sr. M&A advisor, add value to firms via maximizing Shareholders’ value.
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Just some head lights on the texhnical analysis. Generally speaking, Seven ways to forecast any line item is your financials, big numbers, small numbers, average, Y-O-Y, common size, cycles and finally last year figures. Your successful way is to examine those seven ways in your line item and if you find more than one way is applicable then this is the right way. Back to FOREX, usually due to high modulation in fluctuations of this line item, generally the cyclic way of forecast would be the right one. Meaning that, every three years numbers are repeating in cycle. In other words year 4 will equal year one and so on.

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3 Apply a forecasting model

The third step to forecast foreign exchange risk is to apply a forecasting model, which is the mathematical formula or tool you use to generate your predictions. There are many forecasting models available, such as regression models, time series models, neural networks, and simulation models. Each model has its own assumptions, strengths, and limitations, so you need to choose the one that best suits your data, method, and objectives. You can use software, online platforms, or spreadsheets to apply your chosen model and obtain your forecasts. You can also use multiple models and compare their results to increase your confidence and reduce your errors.

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4 Evaluate your results

The fourth step to forecast foreign exchange risk is to evaluate your results, which is the process of checking the accuracy and reliability of your forecasts. You can use various metrics and techniques to evaluate your results, such as mean absolute error, root mean square error, mean absolute percentage error, and confidence intervals. You can also use backtesting, which is the method of comparing your forecasts with the actual exchange rates that occurred in the past. You can use these methods to measure your performance, identify your sources of error, and adjust your model or method if needed. You can also use your results to plan your hedging strategies, which are the actions you take to reduce or eliminate your foreign exchange risk.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Vikesh Kumar, MBA

Ph.D. Candidate (ABD)
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What I can recall from my International Financial Management class is that, first companies need to identify the type of exposure they are facing then based on the exposure forecasting method can be applied. It can be either a Time series, stochastic, or any simple ANOVA method.

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How can you forecast foreign exchange risk?

1

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3

4

5

1 Identify your exposure

2 Choose a forecasting method

3 Apply a forecasting model

4 Evaluate your results

5 Here’s what else to consider

Budgeting & Forecasting

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How can you forecast foreign exchange risk?

1

2

3

4

5

1 Identify your exposure

2 Choose a forecasting method

3 Apply a forecasting model

4 Evaluate your results

5 Here’s what else to consider

Budgeting & Forecasting

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