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Analyzing the Accuracy of Foreign Exchange Advisory Services: Theory AndEvidence

  • Richard M. Levich
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    With the introduction of floating exchange rates, the variability of unanticipated exchange rate changes has increased dramatically. A small forecasting industry has developed to provide information about future exchange rates. From an academic viewpoint, it is of interest to examine some of the statistical properties of these forecasts and to relate the forecast errors to other fundamental economic variables in a model with rational behavior. Second, from a more practical viewpoint, we would like to know if foreign exchange forecasts are useful to decision makers. The purpose of this paper is to provide an objective analysis which addresses some of the above questions for a large sample of forecasts. On the basis of the current research, we can draw several conclusions. First, most advisory service forecasts are not as accurate as the forward rate in terms of mean squared error. Second, judgmental forecasters are superior to econometric forecasters for short-term forecasts; the relationship is reversed for longer-term forecasts (one year). Third, two statistical tests indicate that the fraction of "correct" forecasts is significantly larger than what would be expected if the advisory services were only guessing at the direction of the future spot rate. In this sense, the forecast services appear to demonstrate expertise and usefulness. However, a full analysis of the risk-return opportunities available to advisory service users is still incomplete. It should be cautioned that if the forward rate contains a risk premium, then we expect advisory service models to beat the forward rate according to the tests we have outlined. In this case we must measure speculative returns relative to a risk measure. While advisory service forecasts may lead to profits, they may not be unusual after adjusting for risk.

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    File URL: http://www.nber.org/papers/w0336.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0336.

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    Date of creation: Apr 1979
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    Publication status: published as Levich, Richard M. "Analyzing the Accuracy of Foreign Exchange Advisory Services: Theory and Evidence." Exchange Risk and Exposure: Current Developments in International Financial Management, ed. by Richard M. Levich and Clas G. Wihlborg, (1980). Lexington Books, Lexington, MASS.
    Handle: RePEc:nbr:nberwo:0336
    Note: ITI IFM
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    1. Fama, Eugene F, 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417, May.
    2. Grossman, Sanford J & Stiglitz, Joseph E, 1976. "Information and Competitive Price Systems," American Economic Review, American Economic Association, vol. 66(2), pages 246-53, May.
    3. Figlewski, Stephen C, 1978. "Market "Efficiency" in a Market with Heterogeneous Information," Journal of Political Economy, University of Chicago Press, vol. 86(4), pages 581-97, August.
    4. Lloyd-Davies, Peter & Canes, Michael, 1978. "Stock Prices and the Publication of Second-Hand Information," The Journal of Business, University of Chicago Press, vol. 51(1), pages 43-56, January.
    5. McDonald, John G, 1973. "French Mutual Fund Performance: Evaluation of Internationally-Diversified Portfolios," Journal of Finance, American Finance Association, vol. 28(5), pages 1161-80, December.
    6. Baron, David P, 1976. "Flexible Exchange Rates, Forward Markets, and the Level of Trade," American Economic Review, American Economic Association, vol. 66(3), pages 253-66, June.
    7. Roll, Richard & Solnik, Bruno, 1977. "A pure foreign exchange asset pricing model," Journal of International Economics, Elsevier, vol. 7(2), pages 161-179, May.
    8. Scholes, Myron S, 1972. "The Market for Securities: Substitution versus Price Pressure and the Effects of Information on Share Prices," The Journal of Business, University of Chicago Press, vol. 45(2), pages 179-211, April.
    9. Cornell, Bradford, 1977. "Spot rates, forward rates and exchange market efficiency," Journal of Financial Economics, Elsevier, vol. 5(1), pages 55-65, August.
    10. Goodman, Stephen H, 1979. "Foreign Exchange Rate Forecasting Techniques: Implications for Business and Policy," Journal of Finance, American Finance Association, vol. 34(2), pages 415-27, May.
    11. Jaffe, Jeffrey F, 1974. "Special Information and Insider Trading," The Journal of Business, University of Chicago Press, vol. 47(3), pages 410-28, July.
    12. Makin, John H, 1978. "Portfolio Theory and the Problem of Foreign Exchange Risk," Journal of Finance, American Finance Association, vol. 33(2), pages 517-34, May.
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