Forecasts: Love them? Hate them? Use them

Everybody loves a forecast and wants to know where dollar-rupee is headed. This is natural because forex is the business of every importer/exporter. Even the RBI conducts a Survey in which it seeks the views of professional forecasters on various aspects of the economy, including the Rupee.

Yet, people tend to have very low respect for forecasters. This is not so much because their forecasts tend to go wrong. What people do not like is the lack of sense of accountability displayed by many forecasters, whether in banks, in companies, or outside. Even G Padmanabhan, Executive Director, RBI, lamented this fact at his recent “Goa to Goa” speech on 23rd August.

He said, “If we accept that market makers/ analysts who often are in a position to influence the market sentiment tend to be either euphoric or despondent (at crucial market turning points), what is the accountability if their forecasts turn out to be widely wrong…?” The words in the brackets are ours.

Responsibility

Forecasters need not be defensive on hearing the above statement. Accountability does not mean the forecaster has to make good the losses suffered by a client on account of an incorrect forecast.

However, forecasters should bring in accountability by (a) admitting to mistakes and correcting subsequent forecasts and (b) publishing a track record of the reliability of their forecasts based upon the directional and numerical accuracy of the forecast when compared with the actual market rates that occur afterwards; and pre-informing a prospective client of it.

We invite you, Dear Reader, to take a look at our track record by clicking on http://www.72pct.com

Further, suggesting proper ways to use a forecast is another way of discharging responsibility towards a client. We’ll take that up just a little later.

Reliability, not Accuracy

Before that, the client too has to acknowledge that forecasting is not a science. It is an art, a skill, practiced in the most uncertain conditions. As such, the client needs to look for broad reliability, rather than expect pin-point accuracy.

Also, profits or losses come from the market itself, and would accrue to the exporter/ importer whether or not he uses a forecast. The job of a skilled forecaster is not to guarantee, but to help

increase the chances of a profit and decrease the chances of a loss. So, wanting compensation for a wrong forecast is incorrect.

Of course, an unskilled forecaster would increase the chances of a loss. Therefore, a client would do well to seek out the services of a reliable forecaster.

Three types

Further, it is important to know that the market moves either up, down or sideways. Most people tend to ignore the last possibility even though it generally has a large probability.

Also, sometimes the outlook is clear and sometimes it simply is not. Such a situation usually arises after the market has been ranged for a long time, and usually means that a big trend movement is going to take place once some news emerges that can break the uneasy equilibrium that exists at the time.

The forecaster should spell out the conditions as clearly as he can. And, the client should see what best he can do in the circumstances.

How to Use

The question before an exporter/ importer is not whether he should hedge or not.

He should. The questions are how much to hedge and how to hedge.

How much to hedge? The client should not hedge everything based on any one single forecast. This is because (a) any one single forecast of even a reliable forecaster has no more than a 50 per cent chance of being correct and (b) prudent risk management says that one should never hedge 0 per cent , nor 100 per cent and certainly not at one go.

Small amounts should be hedged over a period of time, slowly building up to a full hedge.

How to hedge? The forecast should be used to choose the hedging instrument. If the forecast is that the Dollar will move up, the Importer can buy a Forward and the Exporter should buy a protective Put. On the flip side, if the Dollar is expected to fall, the Exporter should sell Forward and the Importer should buy a protective Call.

And when the market has been ranged sideways for a long time, both should buy protective out of the money Calls and Puts.

The important point here is that when the Exporter and Importer buy a Put or a Call respectively, they protect themselves against the danger of a forecast going wrong while allowing themselves the opportunity of benefiting if the forecast is right.

People would do well to sanction a hedging cost budget, in order to be able to buy Options. Remember, sanctioning a hedging cost budget is the first step to hedging success.

While forecasters should definitely act with responsibility, clients too can use forecasts better. Here’s to more effective risk management!

(The author is Chief Currency Strategist at kshitij.com. The views are personal. He can be reached at >vikram@kshitij.com )

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