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Figure 8.2 Technical analysis: moving-average rule (5- and 20-day moving averages) Source: C. J. Neely, "Technical Analysis in the Foreign Exchange Market: A Layman's Rule," Review, Federal Reserve Bank of St. Louis, Sept./Oct. 1997, p. 24.

A market-based forecast is a forecast based on market indicators such as forward rates. The empirical evidence on the relationship between exchange rates and market indicators implies that the financial markets of industrialized countries efficiently incorporate expected currency changes in the spot rate, the forward rate, and in the cost of money. This means that we can obtain currency forecasts by extracting predictions already embodied in spot, forward, and interest rates. Therefore, companies can develop exchange forecasts on the basis of these three market indicators.

Spot rates Some companies track changes in the spot rate and then use these changes to estimate the future spot rate. To clarify this point, assume that the Mexican peso is expected to depreciate against the dollar in the near future. Such an expectation will cause speculators to sell pesos today in anticipation of their depreciation. This speculative action will bid down the peso spot rate immediately. By the same token, assume that the peso is expected to appreciate against the dollar in the near future. Such an expectation will encourage speculators to buy pesos today, hoping to sell them at a higher price after they increase in value. This speculative action will bid up the peso spot rate immediately. The present value of the peso, therefore, reflects the expectation of the peso's value in the very near future. Companies can use the current spot rate to forecast the future spot rate because it represents the market's expectation of the spot rate in the near future.

Forward rates The expectation theory assumes that the current forward rate is a consensus forecast of the spot rate in the future. For example, today's 30-day yen forward rate is a market forecast of the spot rate that will exist in 30 days.

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