Philippine foreign exchange rate forecasting: A comparison of accuracy between financially-computed and short term interest rates

• Main Authors: Cabral, Ericka, Co, Genevieve Anne, Gargar, Maria Edaliza, Nuñez, Jessica Angela
• Format: text
• Language: English
• Published: Animo Repository 2008
• Subjects: Foreign exchange rates > Philippines > Forecasting
• Online Access: https://animorepository.dlsu.edu.ph/etd_bachelors/14452
• Institution: De La Salle University

Exchange rates critically impact economic and financial developments of a country. It is a way of intermediation in international finance and a linkage towards globalization. Since there is no known universal medium of exchange, exchange rates are essential for international trade to subsist. The foreign exchange market is where the trading of currencies occurs and can be regarded as recognition of the importance of exchange rates. Hence, forecasting exchange rates can be crucial because the volatility of the forex market is instantaneous. This study uses two variants of the unrestricted Vector Autoregression Model with one distinct differing variable, the interest rate, in attempting to forecast the foreign exchange rate of the Philippine Peso to US Dollars. For the first model, the interest rate is the 91-day T-Bill rate. For the second model, the interest rate is the yield to maturity of a domestic bond computed as the geometric mean of the yield on a sequence of short-term instruments which makes use of the market expectations (pure expectations) hypothesis. The variables used are market rate of Peso to Dollar, money supply, interest rate, inflation rate, real GDP, OfW remittances and relative price of Philippine and US commodities. The time series data covers the period from the first month of 1998 to the ninth month of 2008. For the next twenty seven months, the exchange rate of the Peso vis-a-vis the US Dollar for the first model is expected to decline continuously. Based on the results of the second model, the exchange rate is expected to increase for sometime but will decline again. The appreciation of the domestic currency can be caused by export-led growth, rapid productivity growth in the traded goods sector and to some extent, OFW remittances while the depreciation of the domestic currency can be caused by an increase in the inflation rate and theoretically, the money supply. Ambiguity in the results can be attributed to the intervention of monetary authorities such as the Central Bank whose purpose is to stabilize price levels and regulate the economy. Interest rate, money supply, OFW remittances and relative prices are the four variables in the model that Granger cause exchange rates. The forecasted exchange rate using the financially computed interest rates seems to predict more accurately than the other model. This finding establishes a method which provides a feasible way to generate long-term yields on instruments when only short-term rates are available. Finally, the favorable results imply that the assumptions lying behind the market expectations hypothesis of the term structure of interest rates apply to the Philippine setting.