Forecasts and Discounting

When it comes to exchange rates, or any other financial instrument that is traded in an exchange, we should expect a reaction to any sort of data surprise, either positive or negative. If no surprises are recorded, then we would expect no change in the exchange rate. The idea is that experts aim to provide a forecast on the future values of important variables such as inflation, and other important determinants of exchange rates.

Usually, more than one expert is asked to provide his or her opinion about the future value of an economic variable. Opinions from many experts are then grouped, and a “Consensus Forecast” is produced, which indicates the average of many forecasters’ estimations. Given that such data are usually available in most economic calendars, traders observe them and tend to discount this information: if the forecast suggests that a country will be better off in the future this is factored in the exchange rate, as soon as traders view it.

This is simply an anticipation effect: if many traders believe that the improvement in the country’s prospects should appreciate the exchange rate in the future, then they will go long on the currency now, when the exchange rate is lower, in order to hold it until the price increases in the future. Naturally, as many traders seek to do this, the exchange rate will appreciate from higher demand.

Still, given the fact that this is just a forecast, most traders would not be willing to factor in the whole effect. In essence, if the trader estimates that the forecast would suggest an overall appreciation of the currency by 2.5%, he may not be willing to place his money on a 2% appreciation given that this is simply a forecast which could be wrong. The trader would more likely be willing to go long on the exchange rate until it had increased by, say 1.5%, leaving the extra 1% as a margin of safety given that the forecast could go wrong. This well-justified unwillingness of the traders to go all, means that the exchange rate would not increase by the expected 2.5%, but by a lower percentage. This can be viewed as a “discount” in the “correct” value of the exchange rate and hence the term “discounting”.

The fact that traders discount means that exchange rates, commodity prices, and stock prices, usually tend to be broadly in line with forecasts. Thus, when a data release will agree with its respective Consensus Forecast we can expect little change in the market price. What would move prices and exchange rates is when actual data releases do not agree with forecasts. In that case, what matters is the degree of deviation from the forecast: if the forecast was suggesting that the economic situation should be average and the actual release says that the economy is doing well, then we should expect an improvement (appreciation) of the exchange rate. If the forecast was suggesting that the economic situation should be bad and the actual release says that the economy is doing well, then we should a very strong improvement of the exchange rate.