Forecasting foreign exchange rates is notoriously difficult. Economists don’t have a standard model of what determines exchange rates, and even the most brilliant and closely-reasoned forecast can run off the tracks as events unfold. But multinational corporations and global fund managers must have forecasts in order to select foreign activity priorities and to protect against catastrophic loss.
Exchange rates tend to be more highly trended than other financial price series (such as individual equities). This is because the institutional and economic variables underlying exchange rates tend to move slowly, such as relative inflation rates.

Companies hedging an underlying business position are given clear advice on whether to buy or sell.

Even so, exchange rates are not always trended, which has two critical
consequences for the international firm:

• First, the manager has to decide whether technical analysis is correctly identifying a trend. The best way to make that judgment is to determine whether techni-cal signals are consistent with the Big Picture fundamentals.
• The second critical issue is what to do about a new signal; this entails a re-evaluation of the firm’s exposures, and the risks and rewards of taking alternative actions.
  

So, knowing the context of the decisions at hand is of paramount importance. There is no single correct answer to the question “Where is the Japanese yen going?”

First, we need to know the timeframe over which the answer will be applied - uncertainty increases geometrically with distance into the future.

Fundamental economists may get the direction of exchange rate moves right, but they hardly ever get the timing right. A solution to this problem is technical analysis, which uses statistics to identify trends. The premise of technical analysis is that the price alone contains all the information we need to know about market sentiment, and a trend once in place will continue until something comes along to reverse it. That “something” can be a government policy change, new information about the state of an economy, or just a fresh way of looking at a currency. Whatever factor is dominant at the moment doesn’t matter: the price reliably reflects the sum of market perceptions about the currency.

In our Japanese yen example, the intermediate model system may be showing that the yen is getting stronger and should be bought or hedged, while our long-term system shows that in a wider timeframe, it is weakening and should be sold. To reconcile such discrepancies, we consult the “Big Picture” fundamental economics - with an eye on the firm’s exposure.

Foreign exchange management is a continuous process of trying to hit a moving target. The Rockefeller approach is to use all available tools, fundamental and technical, to achieve excellence in the management process. We define excellence not as “being right” more than 50% of the time, a common misconception, but rather always knowing the range of possible outcomes, i.e., reducing uncertainty over the chosen timeframe.

The Rockefeller Methodology

We employ a highly disciplined quantitative methodology. “Technical analysis” can be of several different types, including cycle theories, “neural networks,” and other schools of thought. RTS has designed its proprietary technical analysis system using a combination of well-tested statistical modeling techniques.

Each currency has a customized set of models, which are weighted and combined in a “confirmation approach.” Two of the models use the moving average crossover concept, whereby the current spot price rising above various moving averages generates a “buy” or “uptrend” signal. Moving average models are the workhorses of statistical analysis and are robust in identifying new trends-- but they are backward looking, or lagging indicators.

The second valuable concept in statistical analysis is momentum, which captures the rate of change in a price series. This is a current indicator; a price moving up with greater acceleration is statistically more significant than a price moving more slowly.

We use two momentum models for each currency. Finally, we wish to measure volatility. A period of low volatility, in which a price moves significantly less than its statistically-defined “average true range”, usually precedes a breakout either up or down.

Volatility models are forward-looking; we use two volatility measurement models. We weight each of the models and generate buy/sell signals based on the sum of the weights. These models were designed and developed in 1990 and have been little changed since; they are simple and powerful, and tend to remain successful as the global environment changes over time.

Our modeling system is scientific in the sense that anyone using the same price series and the same statistical models could replicate it. Technical analysis out performs human judgment over long periods of time, even when new signals may seem to be counter-intuitive. We never override the system output with judgment. The decision to ignore, or override a technical signal belongs to the client, and we offer commentary and consulting to refine that decision.