Forecasting Short-Term Exchange Rates: A Recurrent Neural Network Approach

Movements in foreign exchange rates are the results of collective human decisions, which are the results of the dynamics of their neurons. In this chapter, we demonstrate how to model these types of market behaviors by recurrent neural networks (RNN). The RNN approach can help us to forecast the short-term trend of foreign exchange rates. The application of forecasting techniques in the foreign exchange markets has become an important task in financial strategy. Our empirical results show that a discrete-time RNN performs better than the traditional methods in forecasting short-term foreign exchange rates. 701 E. Chocolate Avenue, Suite 200, Hershey PA 17033-1240, USA Tel: 717/533-8845; Fax 717/533-8661; URL-http://www.idea-group.com ITB9536 IDEA GROUP PUBLISHING This chapter appears in the book, Neural Networks in Business Forecasting, edited by G. Peter Zhang. Copyright © 2004, Idea Group Inc. Copying or distributing in print or electronic forms without written permission of Idea Group Inc. is prohibited. 196 Li, Pang, Yu, & Troutt Copyright © 2004, Idea Group Inc. Copying or distributing in print or electronic forms without written permission of Idea Group Inc. is prohibited. INTRODUCTION Exchange rates are important variables in virtually every international financial market decision. Most countries are adopting the floating exchange rate system, under which the exchange rate is free to adjust in response to changing relative macroeconomic conditions. The volatility of exchange rates becomes one of the most important concerns for all types of participants involved in international financial activities. Foreign exchange risk is one of the many business risks faced by multinational companies and its successful management has become one of the key factors in overall financial management. Recently, Marshall (2000) has done a survey on the foreign exchange risk practices of large UK, USA and Asian Pacific multinational companies. The results showed that although multinational companies from different regions might use different techniques in managing foreign exchange risks, all of them emphasized the importance of foreign exchange risk management. Traders in the foreign exchange markets are always actively seeking profit opportunities by trying to forecast exchange rate movements. Some banks are actively trading in the foreign exchange markets. Levich (2001) showed that there was a dramatic growth in income derived from foreign exchange trading for some international banks over the last 20 years. The needs for foreign exchange risk management and profit opportunities from foreign exchange trading provide a great incentive for participants in the foreign exchange markets to develop a reliable forecasting model of exchange rate movements. Economists have studied exchange rates intensively for the last 25 years. The international parity conditions that are built on purchasing power, interest rates and market expectations have become the fundamental theories in explaining the determination of exchange rates and can be found in all textbooks on international finance nowadays. There appears to be consensus that the long-term trend of exchange rate movements is mainly determined by the structural macroeconomic variables such as the balance of payments, inflation rate, interest rate and money supply. Yet, to many economists exchange rate models built around a set of structural macroeconomic variables seem to have little power to explain the patterns of short-term exchange rate behavior. One extreme view advocated by the market efficiency theorists is that if the foreign exchange markets were efficient, the exchange rates should follow a simple random walk and evolve strictly according to the new information arriving in the markets. If markets are efficient and prices fully reflect all available information, including structural economic information, then unanticipated exchange rate movements are only the results of unanticipated 16 more pages are available in the full version of this document, which may be purchased using the "Add to Cart" button on the publisher's webpage: www.igi-global.com/chapter/forecasting-short-termexchange-rates/27251