978-1337269964 Chapter 9 Solution Manual Part 1

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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?

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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:

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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?

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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.

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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

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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.

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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?

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