Shivani Agrawal

[Document title]

[Email address]

[Document subtitle]

PREFACE
This paper discusses the aspects of forecasting of foreign exchange rate in terms of the Random Walk Model and
Technical analysis. It aims to find out the best frequency which matches our forecast out of six given frequency
data (daily, weekly, monthly, quarterly, semi-annually and annually). Using recent Japanese Yen India Rupee
(JPY/INR) exchange rate data project examines the implications, of data frequency and linearity, on the RWH.

CONTENT

THEORY
The Efficient Market Hypothesis (EMH) suggests that the stock prices fully reflects all available
information of the market about the stock prices, thus the investors doesnt have arbitrage opportunity
constantly. In weak form of EMH, the prices follows a random-walk. A random walk is model is one that
suggests that the next change will be zero, that is the prices are equally likely to go up or down in the next
period and has zero correlation with what has happened in the past.

A BASIC RANDOM-WALK MODEL

A basic form of RW can be written as:

Yt = + Yt-1
Here, Yt

= logarithm of exchange rate at time t

Yt-1 = logarithm of exchange rate at time t-1 (lag is one)
= drift parameter.
In the Forex market, the theory has serious implications so that the investors and other market
participants do not make unusually high profit than the average of market through exploitation of previous
available information. The existence of a random walk in a market confirms that current prices are
independent of past prices, and thus the market is efficient.
When we deal with time series where there is irregular trend, instead of directly predicting the values (Yt)
at each time period, it may be convenient to predict the change occurred between the present and the
next period (Yt - Yt-1). Thus we check the first difference series for presence of any predictable pattern. If
the next change can be predicted, then the change may be added to the current price to get the next
price. RW model suggests that the next change will be always zero. Hence making it impossible to
predict.
The following picture demonstrates that at every intersection, it is equally likely to either go up or down,
hence a random process.

THE DRUNKYARD ANALOGY

It is a commonly-used analogy for a random-walk is the path followed by a drunkard who
moves unsteadily from one pole to another. AT each pole he faces a memory loss and hence
has no idea where he came from.

TECHNICAL ANALYSIS:
The methods primarily used for the analysis of exchange rates can be broadly divided into
fundamental analysis and technical analysis. While fundamental analysis deals with
analyzing the intrinsic value of the firm or industry, so to say. Where as technical analysis
largely deals with figuring out the hidden patterns and trends in the market. Technical
analysis focus mainly of the historical data and the concept of intrinsic value is neglected. In
an attempt to study the market itself by studying the supply and demand factors in the
market to determine the direction the trend might most possibly move.
MOVING AVERAGE:
While technical analysis employs us with a variety of tools to study and comprehend data,
we mainly focus on a particular indicator called Moving Average. This specific method of
deduction helps the investor get a better sense of the overall trend.
International markets can be quiet volatile. This adds a lot of white noise making the price
charts hard to comprehend. This is where Moving Average kicks in, it is the average price of
the security (exchange rate in our case) over a set of time. By plotting the average security
line of the price chart, data gets smoothed out eliminating the day-to-day noise. This helps
traders to identify the true trend as well increase the probability in their favor.
The moving average type we consider for the course of this assignment will be Simple
Moving Average(SMA). In SMA we calculate the average of a fixed interval of data points.
The length of of average set is determined by the level of sensitivity we want the indicator
to smooth out.
In the figure below we can observe the two most commonly used SMA length sets, the 50day MA(Red Line) and 200-day MA(Yellow line).

In the above fig we are looking at the GBP-AUD exchange rate over the past 15 months and
as we can see the 50-day MA clearly chalks out the fall in rate while the 200-day MA shows
the long-term drift in the rate.

Usually the Quarterly MA is adjusted to the change in trends as thats when usual policy
changes kick in. sometimes the monthly MA also does great in this area, as even though we
neglect the intrinsic value of the data in technical analysis, it always widens our perspective
to consider the reason for abnormal changes in the trend and such changes occur generally
after policy changes. So in theory, either the monthly or the quarterly data should give us
the right momentum of the trend.

Understanding the moving averageTrendsIdentifying trends is one of the key utilities of the MA. The MA is a lagging indicator, which
means it can only validate trends once they have been established. New trends can only be
predicted on the probable understanding of the movement. Now coming to confirming
trends, an uptrend is expected when the actual prices are moving above the MA and
downtrends are expected when prices plummet below the MA.
MomentumAs mentioned already the momentum of markets can be precisely determined by the length
of the average. It should come to common sense than a MA with a smaller length should
predict market sensitivities better determining the short term momentum of the market and
a MA with bigger length should determine the long-term momentum, validating the long
tem trend.
Support and ResistanceOne of the essential use of MA is to determine the price support and down trend resistance.
It does not take much to notice that the falling price of an asset will often stop and reverse

direction at the same level as an important average. And once the price of an asset falls below an
influential level of support, such as the 200-day moving average, it is not uncommon to see the
average act as a strong barrier that prevents investors from pushing the price back above that
average

Stop-LossesThe support and resistance factors of the MA help use mitigate risk, leveraging which profits are
expected. The ability of MA to identity the Stop-Loss orders help traders to minimize the losses
when the market goes against the expected trend. Find the right balance to set the Stop-loss
indicators is the key to successful trading strategy.
ECONOMIC IMPORTANCE OF JPY/INR EXCHANGE RATE

Methodology
We also make use of the well-known Augmented Dickey-Fuller unit root test and Philip Perron
unit root tests to check the stationarity of given data. To clearly define the methodology used, it
is necessary to mention the two inference of the RWH. The first being, the increments of
observational periods are not correlated. The second implication is that expected future
exchange-rate increments cannot be predicted. That is the time series does not possess a unit root
This paper focuses on testing the second inference.
The forecasting model used in this paper is a random-walk-without-drift model. (). It tells that at
each point, there is a random increment (decrement) with mean value zero.
Yt = Yt-1

If it is other than zero (say ), then the model is random-walk-with-drift.

i.e. Yt = + Yt-1
The reasons for not including a drift term is that that exchange rates does not have a long
term tend in one direction. This is shown in the table given below.
The mean for daily change is in deciding whether to include a drift term in the model, and if
so, how to estimate its value. In the case of exchange rates, there is no reason to assume a
long-term trend in one direction or the other, at least, not a trend that would stand out
against the noise. The mean daily change is 0.000012 for this sample of exchange rate
data, and the standard error of the mean is 0.00012, so the sample mean is different from
zero by only 1/10th of a standard error, which is not significant by any measure. Again,
though, the mean value of the steps in a finite sample of random-walk data generally does
not provide a good estimate of the current rate of drift, if any.
Overall, then, it appears that a random-walk-without-drift model is appropriate for this time
series.

UNIT ROOT TEST

Augmented Dickey-Fuller Test
This test is used to examine unit roots in a time series. The original, auto regressive equation
is as follows,
Yt = Yt1 +
Taking the first difference, the equation becomes,
Y Yt1 = Yt1 Yt1 +
Or, Yt Yt1 = ( 1) Yt1 +
substituting, ( 1) = ,
we get, Yt = Yt1 +
We consider the following hypothesis and perform a one-tailed test to check for stationarity.
H0: = 0, i.e., there is a unit root and the time series is non-stationery.
H1: < 0, i.e., the series is stationery
If = 0, alternatively, = 1, we cannot reject the null hypothesis, that is the series has a unit root
and is non-stationery.
If < 0, alternatively, < 1, we reject the null hypothesis and state that the series is stationery.
In stata, we reject the null hypothesis only and only if |t-statistic| > |critical value| or MacKinnon
p value > (at respective confidence interval).
In ADF test, the enough lagged differenced term are included so that the serial correlation
between the error terms is removed.
The ADF equation without drift which is used in the model is as follows:
Yt = Yt1 + iYti + , where , i, are coefficients.
In our analysis a lag of 2 is used.
Yt = Yt1 + a1t + 1Yt1 + 2Yt2
PHILIP PERRON TEST
Just like ADF takes care of independent error terms of DF test by introducing lagged terms,
Phillion Perron use non parametric statistical methods to take care of the serial correlation in the
error terms.

MOVING AVERAGE:
The first step towards determining the moving average is to initially select a length for the MA.
Once the length is decided averages of the actual data set shall be calculated.
In our analysis we studied the 2,3,4,5,6,7,8,9 and 10-day MAs. And a relative study was carried
on so to determine which MA closely mapped out the market trends. To determine the
similarities between the actual data and the respective MAs two methods were devised, while
graphically comprehension was the initial filter, the exact closeness to the trend was recheck by
noticing the absolute difference of the MA from the realized data set. And hence the MA whose
sum of daily variations was the least is best associated as the trend followed by the market and is
further used to guide us invest.

Strategies to analyze MA:

CROSSOVER:
The crossover is one of the basic signals and is preferred among the masses as it removes all
emotion. Basic crossovers as ones in which the price of the asset moves from one side of the MA
and closes on the other. These crossovers are used by traders to point out shifts in momentum
and can be used as the basic entry and exit strategy
The second type of crossover occurs when a short-term average crosses through a long-term
average. This signal is used by traders to identify that momentum is shifting in one direction and
that a strong move is likely approaching. A buy signal is generated when the short-term average
crosses above the long-term average, while a sell signal is triggered by a short-term average
crossing below a long-term average. As you can see from the chart below, this signal is very
objective, which is why it's so popular.
FILTER:
Filters are used as supportive indicators to validate the momentum shifts. One example of filters
is the investors would fixate on trend change once the MA crossover is more than 10% over the
other MA before placing the buy/sell order.
Moving Average Envelope:
Through this indicator we create an envelop around the realized price chart with support and
resistance using the suitable MA. The behavior of the market is studied in this particular
envelop .

Discussion of empirical findings

Moving average:
The graphical analysis of the MA is backed by observing the absolute difference the MA from
the realized price list. By this procedure we get to see which MA closely maps out the actual
trend observed in the market.
MA
2
length
0.009
Least
Mean
85
difference
Daily:

10

0.004
98

0.005
43

0.005
85

0.006
25

0.006
62

0.006
97

0.007
31

0.007
62

In the case of daily prices, the 3-dy MA seems to be the one closest to the realized
movements.

MA
length
Least
Mean
difference

10

0.009
29

0.010
38

0.011
48

0.012
56

0.013
56

0.01448

0.015
36

0.0162
3

0.0170
79

Weekly:

In the case of the weekly MA the 2-day MA has the least mean difference and can be
considered to be following the actual market trend.
Monthly:

MA
length
Least
Mean
difference

10

0.0023
4

0.002
49

0.002
57

0.002
64

0.002
72

0.00279

0.002
87

0.0029
5

0.0030
1

When observing the monthly price charts, the 2-day MA is the closest to the actual market
fluctuations, as can be observed from the above table.

Quarterly:

MA
length
Least
Mean
difference

10

0.009
57

0.009
65

0.009
86

0.010
09

0.010
44

0.0108
1

0.011
24

0.011
73

0.012
21

The above table stands to show that, again the 2-day MA is the closest to the actual MA
trend.
Semi Annual:

MA
2
length
0.013
Least
Mean
26
difference

10

0.013
83

0.014
75

0.015
54

0.016
34

0.017
05

0.018
00

0.018
93

0.01893

Annual:

MA
2
3
4
5
6
7
8
9
10
length
0.1303 0.1380 0.1467 0.1570 0.1622 0.1657 0.1688 0.1693 0.17319
Least
0
2
3
0
8
Mean
difference

Similar to the weekly, monthly and quarterly results the least mean difference for the
semi-annual and the annual signify the closeness of the 2-day MA to the real patterns
and trends of the market.
When we consider the MA over all the data sets, the monthly data seems to show the
least mean difference among the rest of the least mean differences. Hence we can
fixate to the MONTHLY distributions to being the closest to the realized market trend.
Finally, we can conclude that the 2-month MA is the trend indicator we have been
looking for and can be used to mitigate our future investments. The proffered trend
also depends on the investors attitude, as for a long term investor the daily or weekly
data sets are useless, similarly a day trader would prefer the daily and weekly charts
more over the annual or semi-annual charts.
While it is in the nature of MA, that the MA with least length usually maps out the
price chart closest. The MA with the least length usually is susceptible to the
irregularities of the market and also resonates with the market noises. Hence, by
theory the results are in line with the expectations. While this helps us see the microtrends of the market, these may not be helpful to an investor. The test so far conducted

fails to give a holistic view of the trend. To issue the Buy/Sell order, or to strategize
the trade we will be needing more in-depth analysis of the MA