Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
POINT/COUNTER-POINT:
Which Exchange Rate Forecast Technique Should MNCs Use?
POINT: Use the spot rate to forecast. When a U.S.-based MNC firm conducts financial budgeting, it must
estimate the values of its foreign currency cash flows that will be received by the parent. Since it is
well documented that firms can not accurately forecast future values, MNCs should use the spot rate
for budgeting. Changes in economic conditions are difficult to predict, and the spot rate reflects the
best guess of the future spot rate if there are no changes in economic conditions.
COUNTER-POINT: Use the forward rate to forecast. The spot rates of some currencies do not represent
accurate or even unbiased estimates of the future spot rates. Many currencies of developing countries
have generally declined over time. These currencies tend to be in countries that have high inflation
rates. If the spot rate had been used for budgeting, the dollar cash flows resulting from cash inflows in
these currencies would have been highly overestimated. The expected inflation in a country can be
accounted for by using the nominal interest rate. A high nominal interest rate implies a high level of
expected inflation. Based on interest rate parity, these currencies will have pronounced discounts.
Thus, the forward rate captures the expected inflation differential between countries because it is
influenced by the nominal interest rate differential. Since it captures the inflation differential, it should
provide a more accurate forecast of currencies, especially those currencies in high-inflation countries.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
Answers to End of Chapter Questions
1. Motives for Forecasting. Explain corporate motives for forecasting exchange rates.
2. Technical Forecasting. Explain the technical technique for forecasting exchange rates. What are some
limitations of using technical forecasting to predict exchange rates?
© 2018 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.
Forecasting Exchange Rates 2
3. Fundamental Forecasting. Explain the fundamental technique for forecasting exchange rates. What
are some limitations of using a fundamental technique to forecast exchange rates?
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.
5. Mixed Forecasting. Explain the mixed technique for forecasting exchange rates.
6. Detecting a Forecast Bias. Explain how to assess performance in forecasting exchange rates. Explain
how to detect a bias in forecasting exchange rates.
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:
© 2018 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.
Forecasting Exchange Rates 3
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 forecasted
real interest rate movements, to predict exchange rates in the future. Explain at least three limitations
of this method.
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?
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?
© 2018 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.
Forecasting Exchange Rates 4
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
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.
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?
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.
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.
© 2018 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.
Forecasting Exchange Rates 5
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?
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.
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.
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?
Advanced Questions
© 2018 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.
Forecasting Exchange Rates 6
19. Probability Distribution of Forecasts. Assume that the following regression model was applied to
historical quarterly data:
et = a0 + a1INTt + a2INFt-1 + mt
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
mt = 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:
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.
© 2018 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.
Forecasting Exchange Rates 7
ANSWER: This question is appropriate for students with a background in regression analysis. If
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?
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?
© 2018 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.
