Chapter 10
Exchange Rate Determination and
Forecasting
QUESTIONS
1. What is the difference between the ex ante and the ex post real interest rate?
Answer: The ex post interest rate corrects the nominal interest rate with the realized or ex
post rate of inflation; whereas the ex-ante (or expected) real interest rate corrects the nominal
interest rate for expected inflation.
Chapter 10: Exchange Rate Determination and Forecasting
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2. Suppose that the international parity conditions all hold and a country has a higher
nominal interest rate than the United States. Characterize the country’s inflation rate
compared to the United States, the country’s expected exchange rate change versus the
dollar, the country’s currency forward premium (or discount) versus the dollar, and the
country’s real interest rate compared to the U.S. real interest rate.
3. How do fundamental analysis and technical analysis differ?
4. Would technical analysis be useful if the international parity conditions held? Why or
why not?
5. Describe three statistics you should obtain from a currency-forecasting service in order
to judge the quality of its currency forecasts.
6. Does a large increase in the domestic money supply always lead to a depreciation of the
currency?
7. Is a current account deficit always associated with a strong real exchange rate (that is,
one that is overvalued compared to the PPP prediction)?
8. Describe how three macroeconomic fundamentals affect exchange rates.
Answer: According to the monetary exchange rate model, the domestic currency weakens
(strengthens) if the domestic (foreign) money supply increases today or if news arrives that
9. Which simple statistical model yields some of the best exchange rate predictions
available? What does this imply for the value of models of exchange rate determination
to multinational businesses?
10. What is chartism?
11. What is an x% filter rule?
12. What is a moving-average crossover rule?
13. Have currency traders been successful in exploiting their exchange rate forecasts?
Answer: While there exists scant empirical evidence on the forecasting ability of exchange
rate forecasting services, the number of active currency traders, mostly organized as hedge
14. Are devaluations of pegged exchange rates totally unexpected?
15. Construct a list of a country’s economic statistics you would assemble to help determine
the probability of a devaluation of its currency within the coming year.
Answer: Based on theoretical and empirical work, the following economic variables should
PROBLEMS
1. Suppose the 1-year nominal interest rate in Zooropa is 9%, and Zooropa’s expected
inflation rate is 4%. What is the real interest rate in Zooropa?
2. You were recently hired by the Doolittle Corporation corporate treasury to help
oversee its expansion into Europe. Blake Francis, the CFO, wants to hire a foreign
exchange forecasting company. Blake has asked you to evaluate three different
companies, and he has obtained information on their past performances. Out of a total
of 50 forecasts for the $/€ rate, the companies reported the number of times they
correctly forecast appreciations and depreciations:
Correct Down
Forecasts
Correct Up
Forecasts
Morrissey Forex
Advisors
20
5
Pixie Exchange Land
20
4
FOREX Cures
12
12
There are a total of 35 dollar appreciations (down periods) and 15 dollar depreciations
(up periods) in the sample. Blake wants to know two things:
a. Can anything be said about the companies’ forecasting ability with the available
data?
Answer: Yes, one can compute the number of correct “directional” forecasts. Morrissey has
the highest correct proportion with 25 out of 50 correct, whereas the other firms have less
b. What additional information should Blake try to obtain in order to form a better
judgment?
Chapter 10: Exchange Rate Determination and Forecasting
3. Mini-Case: Currency Turmoil in Zooropa
Fad Gadget has never worked so hard in his entire life. It is near midnight, and he is
still poring over statistics and tables. Fad recently joined Smashing Pumpkins, a
relatively young but fast-growing British firm. Smashing Pumpkins produces and
distributes an intricate device that turns fresh pumpkins into pumpkin pie in about 30
minutes. Recently, the firm has started exporting to Zooropa. Some of the largest and
tastiest pumpkins are grown in Zooropa, and Zooropa’s population boasts the highest
per capita pumpkin consumption in the world. A recent analysis of the pumpkin
market in Zooropa has left the company’s senior managers very impressed with the
profit potential.
Although Zooropa consists of 10 politically independent countries, their
currencies are linked through a system called the Currency Rate Linkage System
(CRLS) that works exactly like the former Exchange Rate Mechanism (ERM) of the
EMS worked before the currency turmoil started in September 1992. The anchor
currency is the banshee of Enigma, the leading country in Zooropa.
Initial contacts with importers in Zooropean countries indicated that they
typically insist on payment in their own local currency. About a week ago, Cab
Voltaire, the CEO of Smashing Pumpkins, expressed concerns about this development
and asked Fad to lead a research team to further examine the present state of the
currency system of Zooropa. Cab viewed the outlook for the banshee relative to the
pound quite favorably and did not predict any substantial depreciation of the banshee
against any other major currency. However, the precarious economic situation of some
of the countries in Zooropa and the growing importance of speculative pressures in
Zooropa’s currency markets last week suddenly made him suspicious about the
possibility of realignments within the system. He even doubted the long-term viability of
the system. Cab instructed Fad to examine the following issues:
Which currencies in the system exhibit the highest realignment risk?
If a currency realigns and gets devalued, what are the effects on our sales
and profit margins in this particular country? Can we take the realignment
possibility into account in our pricing?
Suppose a currency is forced to leave the CRLS. What are the effects on
exchange rates, interest rates, and the outlook for sales in that country?
What is the likelihood of this occurring for the different countries?
Fad Gadget felt nervous. A meeting was scheduled with Cab the day after
tomorrow. He wanted to write a thorough and insightful report. At the last
management meeting, he had the uneasy feeling that some senior managers doubted his
abilities. Some managers were naturally suspicious of a young Australian newcomer
with his MBA. His earring and punk hairdo did not exactly help either. His team of
analysts had already assembled a table with relevant macroeconomic and financial data
Chapter 10: Exchange Rate Determination and Forecasting
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(see Exhibit 10.11). “If only I could use this to rank the different countries according to
realignment risk,” he thought.
a) Realignment rankings
The data provided are a scrambled version of an Exhibit that appeared in the Economist of
September 19, 1992, when a currency crisis in Europe had just erupted. The Exhibit presented
Who’s Next?
Legend for Chart:
A – Currency’s ERM position Sept 15th
B – Currency’s over/under valuation, %
C – Reserves, import cover
Chapter 10: Exchange Rate Determination and Forecasting
b) Effects of Realignments/Exits for the Firm
Since the British firm agrees to local currency pricing, the risk is that the Zooropa currencies get
devalued. Two cases must be considered:
(1) The price remains fixed. In this case, the revenue per unit sold in pounds decreases and
Chapter 10: Exchange Rate Determination and Forecasting
10
c) Incorporating Realignment Risk into Pricing/Hedging
The market will anticipate the realignment. In fact, if UIRP holds, the interest differential with
d) Effects of devaluation/exits on exchange and interest rates
Exchange rates fall, by definition. The effect on the interest rate however may be different in
both cases. With devaluation it is very likely that the interest rate will drop. That is because the
Chapter 10: Exchange Rate Determination and Forecasting
11
4. Web Problem: Go to www.oanda.com/currency/big-mac-index. Oanda reports the last
available Big Mac index but then updates the exchange rates on a regular basis to
compare them with the PPP-based exchange rates. What are currently the most under-
valued and over-valued exchange rates? How would you use this information in
forecasting exchange rates?
On June 6, 2011, the most overvalued currency versus the dollar was the Norwegian kroner