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Answers to End of Chapter Questions
1. Motives for Forecasting. Explain corporate motives for forecasting exchange rates.
ANSWER: Several decisions of MNCs require an assessment of the future. Future exchange rates
will affect all critical characteristics of the firm such as costs and revenues. To be more specific,
2. Technical Forecasting. Explain the technical technique for forecasting exchange rates. What are
some limitations of using technical forecasting to predict exchange rates?
ANSWER: Technical forecasting involves the review of historical exchange rates to search for a
Even if a technical forecasting model turns out to be valuable, it will no longer be valuable once other
3. Fundamental Forecasting. Explain the fundamental technique for forecasting exchange rates. What
are some limitations of using a fundamental technique to forecast exchange rates?
ANSWER: Fundamental forecasting is based on underlying relationships that are believed to exist
Even if a fundamental relationship exists, it is difficult to accurately quantify that relationship in a
4. Market-Based Forecasting. Explain the market-based technique for forecasting exchange rates.
What is the rationale for using market-based forecasts? If the euro appreciates substantially against
the dollar during a specific period, would market-based forecasts have overestimated or
underestimated the realized values over this period? Explain.
ANSWER: Market-based forecasts should reflect an expectation of the market on future rates. If the
market’s expectation differed from existing rates, then the market participants should react by taking
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Forecasting Exchange Rates 2
5. Mixed Forecasting. Explain the mixed technique for forecasting exchange rates.
ANSWER: Mixed forecasting involves a combination of two or more techniques. The specific
6. Detecting a Forecast Bias. Explain how to assess performance in forecasting exchange rates.
Explain how to detect a bias in forecasting exchange rates.
ANSWER: Performance can be evaluated by computing the absolute forecast error as a percentage of
A forecast bias exists from consistently underestimating or overestimating exchange rates. If the
7. Measuring Forecast Accuracy. You are hired as a consultant to assess a firm’s ability to forecast.
The firm has developed a point forecast for two different currencies presented in the following table.
The firm asks you to determine which currency was forecasted with greater accuracy.
ANSWER:
Yen Actual Pound Actual
Period Forecast Yen Value Forecast Pound Value
1 $.0050 $.0051 $1.50 $1.51
Absolute Forecast Error as a Percentage of the Realized Value
Period Yen Forecast Pound Forecast
1 1.96% .66%
8. Limitations of a Fundamental Forecast. Syracuse Corp. believes that future real interest rate
movements will affect exchange rates, and it has applied regression analysis to historical data to
assess the relationship. It will use regression coefficients derived from this analysis, along with
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Forecasting Exchange Rates 3
forecasted real interest rate movements, to predict exchange rates in the future. Explain at least three
limitations of this method.
ANSWER: First, the timing of the impact of real interest rates on exchange rates may differ from
Second, the forecasted real interest rates may be inaccurate, causing inaccurate forecasts of the
9. Consistent Forecasts. Lexington Co. is a U.S.-based MNC with subsidiaries in most major
countries. Each subsidiary is responsible for forecasting the future exchange rate of its local currency
relative to the U.S. dollar. Comment on this policy. How might Lexington Co. ensure consistent
forecasts among the different subsidiaries?
ANSWER: If each subsidiary uses its own data and techniques to forecast its local currency’s
10. Forecasting with a Forward Rate. Assume that the four-year annualized interest rate in the United
States is 9 percent and the four-year annualized interest rate in Singapore is 6 percent. Assume
interest rate parity holds for a four-year horizon. Assume that the spot rate of the Singapore dollar is
$.60. If the forward rate is used to forecast exchange rates, what will be the forecast for the
Singapore dollar’s spot rate in four years? What percentage appreciation or depreciation does this
forecast imply over the four-year period?
Country Four - Year Compounded Return
U.S. (1.09)4 – 1 = 41%
Singapore (1.06)4 – 1 = 26%
11.9% =
1-
1.26
1.41
= Premium
ANSWER: Thus, the four-year forward rate should contain an 11.9% premium above today’s spot
11. Foreign Exchange Market Efficiency. Assume that foreign exchange markets were found to be
weak-form efficient. What does this suggest about utilizing technical analysis to speculate in euros?
If MNCs believe that foreign exchange markets are strong-form efficient, why would they develop
their own forecasts of future exchange rates? That is, why wouldn’t they simply use today’s quoted
rates as indicators about future rates? After all, today’s quoted rates should reflect all relevant
information.
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Forecasting Exchange Rates 4
ANSWER: Technical analysis should not be able to achieve excess profits if foreign exchange
12. Forecast Error. The director of currency forecasting at Champaign-Urbana Corp. says, “The most
critical task of forecasting exchange rates is not to derive a point estimate of a future exchange rate
but to assess how wrong our estimate might be.” What does this statement mean?
ANSWER: Point estimate forecasts of exchange rates are not likely to be perfectly accurate. MNCs
13. Forecasting Exchange Rates of Currencies That Previously Were Fixed. When some countries in
Eastern Europe initially allowed their currencies to fluctuate against the dollar, would the
fundamental technique based on historical relationships have been useful for forecasting future
exchange rates of these currencies? Explain.
ANSWER: Fundamental forecasting typically relies on historical relationships between economic
14. Forecast Error. Royce Co. is a U.S. firm with future receivables one year from now in Canadian
dollars and British pounds. Its pound receivables are known with certainty, and its estimated
Canadian dollar receivables are subject to a 2 percent error in either direction. The dollar values of
both types of receivables are similar. There is no chance of default by the customers involved.
Royce’s treasurer says that the estimate of dollar cash flows to be generated from the British pound
receivables is subject to greater uncertainty than that of the Canadian dollar receivables. Explain the
rationale for the treasurer’s statement.
ANSWER: The British pound’s future spot rate is more difficult to predict because of the pound’s
15. Forecasting the Euro. Cooper, Inc., a U.S.-based MNC, periodically obtains euros to purchase
German products. It assesses U.S. and German trade patterns and inflation rates to develop a
fundamental forecast for the euro. How could Cooper possibly improve its method of fundamental
forecasting as applied to the euro?
ANSWER: It should use data for all countries participating in the euro (not just the German data), as
16. Forward Rate Forecast. Assume that you obtain a quote for a one-year forward rate on the Mexican
peso. Assume that Mexico’s one-year interest rate is 40 percent, while the U.S. one-year interest rate
is 7 percent. Over the next year, the peso depreciates by 12 percent. Do you think the forward rate
overestimated the spot rate one year ahead in this case? Explain.
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Forecasting Exchange Rates 5
ANSWER: A quoted forward rate for the Mexican peso would contain a large discount because of
17. Forecasting Based on PPP versus the Forward Rate. You believe that the Singapore dollar’s
exchange rate movements are mostly attributed to purchasing power parity. Today, the nominal annual
interest rate in Singapore is 18%. The nominal annual interest rate in the U.S. is 3%. You expect that
annual inflation will be about 4% in Singapore and 1% in the U.S. Assume that interest rate parity
holds. Today the spot rate of the Singapore dollar is $.63. Do you think the one-year forward rate
would underestimate, overestimate, or be an unbiased estimate of the future spot rate in one year?
Explain.
ANSWER: The forward rate will likely underestimate the future spot rate. The inflation differential
18. Interpreting an Unbiased Forward Rate. Assume that the forward rate is an unbiased but not
necessarily accurate forecast of the future exchange rate of the yen over the next several years. Based
on this information, do you think Raven Co. should hedge its remittance of expected Japanese yen
profits to the U.S. parent by selling yen forward contracts? Why would this strategy be
advantageous? Under what conditions would this strategy backfire?
ANSWER: If the forward rate is an unbiased forecast, the amount of dollars received from
remittances when hedging should be the same (on average, over time) as the amount of dollars
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Forecasting Exchange Rates 6
Advanced Questions
19. Probability Distribution of Forecasts. Assume that the following regression model was applied to
historical quarterly data:
et = a0 + a1INTt + a2INFt-1 + t
where et = percentage change in the exchange rate of the Japanese yen in period t
INTt = average real interest rate differential (U.S. interest rate minus Japanese interest rate)
over period t
INFt-1 = inflation differential (U.S. inflation rate minus Japanese inflation rate) in the previous
period
a0, a1, a2 = regression coefficients
t = error term
Assume that the regression coefficients were estimated as follows:
a0 = 0.0
a1 = 0.9
a2 = 0.8
Also assume that the inflation differential in the most recent period was 3 percent. The real interest
rate differential in the upcoming period is forecasted as follows:
Interest Rate
Differential Probability
0% 30%
1 60
2 10
If Stillwater, Inc., uses this information to forecast the Japanese yen’s exchange rate, what will be the
probability distribution of the yen’s percentage change over the upcoming period?
ANSWER:
Forecast of Forecast of the
Interest Rate Percentage Change
Differential in the Japanese Yen Probability
0% .9(0%) + .8(3%) = 2.4% 30%
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Forecasting Exchange Rates 7
20. Testing for a Forecast Bias. You must determine whether there is a forecast bias in the forward rate.
You apply regression analysis to test the relationship between the actual spot rate and the forward rate
forecast (F):
S = a0 + a1 (F)
The regression results are as follows:
Coefficient Standard error
a0 = .006 .011
a1 = .800 .05
Based on these results, is there a bias in the forecast? Verify your conclusion. If there is a bias,
explain whether it is an overestimate or an underestimate.
ANSWER: This question is appropriate for students with a background in regression analysis. If
Forecasting Exchange Rates 8
21. Effect of September 11 on Forward Rate Forecasts. The September 11, 2001 terrorist attack on the
U.S. was quickly followed by lower interest rates in the U.S. How would this affect a fundamental
forecast of foreign currencies? How would this affect the forward rate forecast of foreign currencies?
ANSWER: Lower interest rates in the U.S. reduce the capital flows into the U.S., which places
upward pressure on foreign currencies against the dollar.
22. Interpreting Forecast Bias Information. The treasurer of Glencoe, Inc., detected a forecast bias
when using the 30-day forward rate of the euro to forecast future spot rates of the euro over various
periods. He believes he can use this information to determine whether imports ordered every week
should be hedged (payment is made 30 days after each order). Glencoe’s president says that in the
long run the forward rate is unbiased and that the treasurer should not waste time trying to “beat the
forward rate” but should just hedge all orders. Who is correct?
ANSWER: Even if the forward rate is unbiased over the long run, Glencoe could save money if it
23. Forecasting Latin American Currencies. The value of each Latin American currency relative to the
dollar is dictated by supply and demand conditions between that currency and the dollar. The values
of Latin American currencies have generally declined substantially against the dollar over time. Most
of these countries have high inflation rates and high interest rates. The data on inflation rates,
economic growth, and other economic indicators are subject to error, as limited resources are used to
compile the data.
a. If the forward rate is used as a market-based forecast, will this rate result in a forecast of
appreciation, depreciation, or no change in any particular Latin American currency? Explain.
ANSWER: The forward rate of each Latin American currency would have a large discount,
b. If technical forecasting is used, will this result in a forecast of appreciation, depreciation, or no
change in the value of a specific Latin American currency? Explain.
ANSWER: Technical forecasting would result in a forecast of depreciation, because the Latin
c. Do you think that U.S. firms can accurately forecast the future values of Latin American
currencies? Explain.
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Forecasting Exchange Rates 9
ANSWER: U.S. firms cannot forecast Latin American currency values accurately, because they
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
