Currency forecast back-testing

The backtesting of exchange rate forecasts highlights the fact that the consensus of analysts is not a reliable estimate of future exchange rates and that it is risky to used them as decision tools for hedging or budget rates.

Each quarter, the largest banks in the world communicate their currency rates forecasts for the months to come. These analyzes often serve as benchmarks for manufacturers and companies to define their budget rates. However, it turns out that they are often off the mark, even in the short term because, by nature, predictions cannot anticipate unforeseeable events.

It emerges from our analyzes that when forecasters anticipate, for example, a 10% deterioration in the spot price over a given horizon, they tend to keep it over time by just re-affecting it to the spot price of the moment, regardless if the price moves in the right direction or in the opposite direction from the initial forecast.

The analysis aforementioned covers 4 currency pairs: EURUSD, EURJPY, EURCHF and EURGBP.

EURCHF and EURUSD: the error of direction of the initial forecast is offset as the spot price evolved in the opposite direction of the forecast during all the period. Then, the forecast, regularly readjusted to the new spot price, ends up being correct despite the permanent error of direction during the period.

EURJPY: the principle is similar with a temporary rebound in the spot price in the meantime reducing the forecast’s error. Then the JPY strengthened and the error resumed its hike.

GBPEUR: the forecast error evolves erratically and does not reduce with the passage of time due to erratic political and economic events.

Conclusion: Forecasts should not be used as decision support tools for hedging decision or budget rates since the banks’ consensus remains fairly close to the spot rate prevailing on the date of the forecast. Other methodologies are more effective to minimize FX gaps.

Below you will find the graphical analysis for 4 currency pairs: EURUSD, EURJPY, EURCHF and EURGBP

EURUSD

EURCHF

EURJPY

EURGBP