GAO-05-800R Foreign Currency Fluctuations 

United States Government Accountability Office

Washington, DC 20548 

June 16, 2005 

The Honorable John Warner 

Chairman 

The Honorable Carl Levin 

Ranking Minority Member 

Committee on Armed Services 

United States Senate 

The Honorable Duncan L. Hunter 

Chairman 

The Honorable Ike Skelton 

Ranking Minority Member 

Committee on Armed Services 

United States House of Representatives 

Subject: Review of DOD’s Report on Budgeting for Exchange Rates for Foreign 

Currency Fluctuations

The Department of Defense (DOD) expends a significant amount of funds overseas, 

particularly from its Operation and Maintenance (O&M) and Military Personnel 

(MILPERS) appropriations. As the rate of overseas currencies fluctuates on a daily 

basis, such fluctuations have an impact on the various expenditures that DOD makes. 

For budgeting purposes, DOD establishes foreign currency exchange rates to 

determine its O&M and MILPERS funding needs. During the fiscal year, DOD incurs 

expenditures at the actual exchange rate, which varies from the budgeted rate. For 

example, if the dollar depreciates in value, more dollars are needed to pay for goods 

and services overseas than originally budgeted. 

Concerned about whether DOD’s method for selecting foreign currency rates has 

produced realistic estimates in its budget submissions, Congress required DOD to 

consider alternative methods. Specifically, the Ronald W. Reagan National Defense 

Authorization Act for Fiscal Year 2005 required the Secretary of Defense to submit a 

report on the foreign currency exchange rate projections used in annual DOD budget 

presentations. 1 The act required that DOD identify alternative approaches, including 

the feasibility of using private economic forecasting and approaches used by other 

federal departments and agencies, for selecting foreign currency exchange rates that 

would produce more realistic estimates of the amounts required for DOD to 

accommodate foreign currency exchange rate fluctuations. DOD also was required 

 

1

 Pub. L. No. 108-375, §1006 (2004). 
Page 2 GAO-05-800R Foreign Currency Fluctuations 

to discuss the advantages and disadvantages of each approach and to identify the 

department’s preferred approach among the alternatives and provide a rationale for 

preferring that approach. Finally, the act further required that we review DOD’s 

report, including the basis for the Secretary's conclusions for the preferred approach. 

DOD submitted its report to Congress on April 15, 2005. 

In response to the act, we examined (1) the extent to which DOD evaluated 

alternative approaches for selecting budgeted foreign currency rates—such as private 

economic forecasting companies or approaches used by other federal departments—

and DOD’s basis for selecting its preferred rate selection approach and (2) the extent 

to which DOD’s preferred approach for forecasting foreign currency exchange rates 

would produce a more realistic estimate than its historical approach. 

In conducting our work, we examined the alternative approaches explored by DOD 

for selecting budgeted foreign currency exchange rates and DOD’s reported 

advantages and disadvantages of each approach. We interviewed responsible 

officials from the Office of the Under Secretary of Defense, Comptroller to obtain 

DOD’s rationale for deciding on its preferred rate selection approach. We 

independently calculated a sample of DOD’s fiscal year 2006 budgeted foreign 

currency exchange rates that were generated using DOD’s preferred approach to 

validate that the rates could easily be replicated. We also compared the use of DOD’s 

preferred approach with its historical approach to determine their impact on 

developing budgetary estimates. We calculated how both the rates generated by 

DOD’s preferred approach and the rates used to prepare the budget submissions for 

fiscal years 2004 and 2005 compared with current actual exchange rates as of May 

2005. We conducted our work from November 2004 to June 2005 in accordance with 

generally accepted government audit standards. 

Summary 

DOD evaluated several alternative approaches for selecting budgeted foreign 

currency rates and selected an approach that it believed would more accurately and 

objectively predict exchange rates. The alternative approaches included (1) 

estimates from a private forecasting company; (2) methods used by other federal 

departments, such as selecting exchange rates on the basis of past execution data 

and using multiple exchange rates for individual offices; and (3) various statistical 

methodologies. DOD selected a statistical method referred to as the centered 

weighted average, which combines both a long-run average of exchange rates and the 

most recently observed exchange rates to predict future exchange rates. DOD chose 

this approach because it was based on historical and current data and could be 

universally replicated; therefore, it was not dependent on subjective judgment. DOD 

used this method in developing its fiscal year 2006 budget submission. DOD believed 

that using a combination of both recent and historical data would be an advantage in 

more accurately predicting future exchange rates because the methodology allows 

DOD to weight individual currencies to minimize the impact of their volatility over 

time. According to DOD, they did not choose the private forecasting alternative 

because of the lack of visibility over key assumptions used in generating the forecast 
Page 3 GAO-05-800R Foreign Currency Fluctuations

nor did they choose one of the methods used by the other federal departments 

because the other departments either did not forecast foreign currency rates or they 

did not have a uniform procedure for setting departmentwide rates. 

DOD selected a reasonable approach for forecasting foreign currency rates that can 

produce a more realistic estimate than its historical approach. Unlike DOD’s 

historical approach, the centered weighted average approach provides a 

straightforward statistical calculation of historical data that can be easily replicated 

with no hidden assumptions and is not dependent on subjective judgment. In 

reaching our conclusion, we compared both the new rates generated using the 

preferred approach and the rates DOD used to prepare the fiscal year 2004 and 2005 

budget submissions based on its historical approach to current actual exchange rates. 

We found that the new methodology generated rates that more closely reflected 

actual exchange rates that occurred during the budget year. 

DOD officials reviewed a draft of this report and agreed with its content. 

Background 

Each fiscal year, DOD establishes budgeted foreign currency exchange rates (units of 

foreign currency per one U.S. dollar) to use when determining its O&M and MILPERS 

funding needs. In past years, DOD tracked foreign currency exchange rates in the 

Wall Street Journal on a daily basis during the months immediately preceding the 

budget submission and then selected the most favorable foreign currency exchange 

rates, which provide the highest amount of foreign currency per dollar, during this 

timeframe. For the fiscal year 2004 budget submission, DOD selected the most 

favorable rates from August through November 2002. For the fiscal year 2005 

submission, DOD did not revise its rates. It continued to use exactly the same rate 

contained in the fiscal year 2004 budget submission. We have previously briefed your 

office in the past that the use of the most favorable foreign currency rates 

underestimates the impact of foreign currency fluctuations and therefore results in a 

budget submission that does not realistically reflect funding requirements for O&M 

and MILPERS expenses. While many methods can be used to forecast foreign 

currency exchange rates, some methods may produce rates that are better estimates 

of actual foreign currency trends. For fiscal year 2006, DOD changed its methodology 

for setting budgeted foreign currency exchange rates and used a centered weighted 

average approach. This approach combines both a long-run weighted average of 

exchange rates and a weighted average of the most recently observed exchange rate 

to predict future exchange rates. 
Page 4 GAO-05-800R Foreign Currency Fluctuations 

DOD Considered Alternative Approaches and Selected a Statistical Method 

In meeting its legislative requirement, DOD considered alternate approaches for 

determining foreign currency exchange rates to use in developing its budget request. 

These approaches included: estimates from a private forecasting company, methods 

used by other federal departments, and various statistical methodologies for selecting 

budgeted foreign currency rates. DOD selected a statistical method, the centered 

weighted average that it thought would more closely reflect actual rates that occur 

during the budget year. DOD used this method to set its fiscal year 2006 rates. 

DOD considered using a private economic forecasting company as an approach for 

establishing budgeted foreign currency exchange rates and cited several advantages 

and disadvantages in its report. According to the report, a private forecasting 

company would provide DOD with forecasted foreign currency exchange rates 

calculated by the company using its own assumptions and methods. It also stated 

that the advantage of using a private forecasting company would be that it provides a 

quick way to acquire foreign currency exchange rates because the rates are already 

established by the company. The report further noted that a disadvantage of using a 

private forecasting company would be that DOD would incur additional costs since 

the department would have to purchase the forecasted rates from the private 

company. Also, DOD stated that another disadvantage would be that the approach 

would not provide a straightforward methodology that could be explained to decision 

makers because the assumptions and methods used to forecast the exchange rates 

are produced and owned by the company and would not be disclosed to DOD. 

Additionally, the report noted that the use of a forecasting company would raise 

questions as to why a particular company was selected instead of another one. 

According to DOD officials, for these reasons, DOD did not consider using a private 

forecasting company to be a viable option. 

In its report, DOD also evaluated approaches used by other federal departments to 

set budgeted foreign currency exchange rates. DOD contacted five federal 

departments but found no foreign currency budgeting procedures in use that would 

meet DOD’s needs. DOD contacted the Departments of Education, Energy, Justice, 

State, and Agriculture. The Departments of Education, Energy, and Justice did not 

purchase foreign currency. Therefore, they had no reason to forecast. The 

Department of State used past execution rates and thus did not forecast future 

market foreign currency exchange rates in its budget submissions. The Department 

of Agriculture used forecasted exchange rates in developing its budget. However, the 

department included 80 different budget estimates from its various offices and each 

office could use a different methodology to produce the forecasted rates. Thus, 

Agriculture had no uniform procedure for setting departmentwide budgeted foreign 

currency exchange rates. Consequently, DOD did not choose one of the methods 

used by another federal department because they either did not forecast foreign 

currency rates or they did not have a uniform procedure for setting departmentwide 

rates. 
Page 5 GAO-05-800R Foreign Currency Fluctuations

DOD also reviewed several statistical methodologies to forecast foreign currency 

exchange rates, such as linear forecasting, moving averages, exponential smoothing, 

simple average, and a centered weighted average. All of these statistical 

methodologies are traditional techniques that use data to predict future trends. DOD 

found that the advantages of statistical approaches are that the methodologies are 

clear and can be replicated. In addition, these statistical methods do not have hidden 

assumptions and the subjectivity associated with DOD’s selection of past foreign 

currency exchange rates would be eliminated. We have previously briefed your office 

that the use of the most favorable foreign currency rates underestimates the impact 

of foreign currency fluctuations and therefore results in a budget submission that 

does not realistically reflect funding requirements for O&M and MILPERS expenses. 

DOD selected the centered weighted average approach as its preferred approach for 

establishing budgeted foreign currency exchange rates for fiscal year 2006. DOD 

believed that this method would result in rates that more closely reflect actual foreign 

currency rates because it combined both a long-run average of exchange rates and 

the most recent observed rates. This approach allowed DOD to weight individual 

currencies thus minimizing volatility over time. The centered weighted average was 

the only statistical methodology that used individual weighting factors for each 

currency to combine recent data with the historical average to predict exchange 

rates. DOD also reported that a possible disadvantage of using this approach would 

be that it could produce a rate that might not appear reasonable if the current market 

exchange rates significantly increased or decreased at the time of the budget 

submission. 

DOD Selected a Reasonable Approach That More 

Realistically Estimates Foreign Currency Exchange Rates 

DOD selected a reasonable approach for forecasting foreign currency rates that can 

produce a more realistic estimate than its historical approach. Unlike DOD’s 

historical approach, the centered weighted average approach provides a 

straightforward statistical calculation of historical data that can be easily replicated 

with no hidden assumptions. This type of calculation eliminates the subjectivity in 

the rate selection process that was present in the method DOD used to set budget 

estimates in prior years, when DOD selected only the most favorable rates for each 

foreign currency. We independently verified DOD’s claim that the rates can easily be 

replicated using this approach. We calculated a sample of DOD’s exchange rates 

using its centered weighted average methodology. Our calculations matched the 

same rates that DOD generated for its fiscal year 2006 budget submission. 

Our analysis shows that DOD’s preferred method for developing foreign currency 

exchange rates for budgetary purposes more closely approximates actual exchange 

rates that occurred during the budget year. We compared both (1) the foreign 

currency rates DOD included in its fiscal year 2006 budget submission using the 

centered weighted average approach and (2) the rates that DOD included in its fiscal 

year 2004 and 2005 budget submissions using the most favorable rates with current 

foreign currency exchange rates as of May 2005. Our analysis showed a projected 
Page 6 GAO-05-800R Foreign Currency Fluctuations 

loss of almost $775 million (potential difference between using the budgeted versus 

actual rates) for fiscal year 2006 using the centered weighted average rates. 

However, DOD would have incurred additional losses of about $908 million, totaling 

about $1.7 billion, had it used the rates it used to build its budget submissions for 

fiscal years 2004 and 2005 to predict its fiscal year 2006 budget estimates. 

Agency Comments 

DOD officials reviewed a draft of this report and agreed with its content. 

_ _ _ _ _ 

We are sending copies of this letter to the Senate and House Armed Services 

Committees. We also will make copies available to others upon request. In addition, 

this letter will be available at no charge on GAO’s Web site at http://www.gao.gov. 

If you have any questions concerning this letter, please contact me at (202) 512-9619 

or pickups@gao.gov. Contact points for our Offices of Congressional Relations and 

Public Affairs may be found on the last page of this letter. Key contributors to this 

assignment were Bonita P. Anderson, Renee S. Brown, Laura L. Durland, Charles W. 

Perdue, Gina O. Ruidera, and Michael C. Zola. 

Sharon Pickup 

Director, 

Defense Capabilities and Management 

(350614) 
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