Chapter 9
Forecasting Exchange Rates
Lecture Outline
Why Firms Forecast Exchange Rates
Forecasting Techniques
Technical Forecasting
Forecast Error
Measurement of Forecast Error
Forecast Accuracy Among Currencies
Using Interval Forecasts
Methods of Forecasting Exchange Rate Volatility
2 Forecasting Exchange Rates
Chapter Theme
This chapter stresses the value of reliable forecasts, but suggests that reliable forecasts can’t always be
Topics to Stimulate Class Discussion
1. Which forecast technique would you use if you were hired by an MNC to forecast exchange rates?
2. Do you think there will ever be a published technical forecasting model that you could use in the
future to most accurately forecast exchange rates? Why or why not?
POINT/COUNTER-POINT:
Which Exchange Rate Forecast Technique Should MNCs Use?
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
Forecasting Exchange Rates 3
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: To the extent that high expected inflation leads to weakness of a currency, the forward rate
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
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
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
4 Forecasting 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.
ANSWER: Market-based forecasts should reflect an expectation of the market on future rates. If the
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
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
Forecasting Exchange Rates 5
Absolute Forecast Error as a Percentage of the Realized Value
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.
ANSWER: First, the timing of the impact of real interest rates on exchange rates may differ from
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?
6 Forecasting Exchange Rates
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.
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
Forecasting Exchange Rates 7
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.
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.
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
8 Forecasting Exchange Rates
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
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
Forecasting Exchange Rates 9
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.
ANSWER: This question is appropriate for students with a background in regression analysis. If
10 Forecasting Exchange Rates
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
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
Forecasting Exchange Rates 11
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.
ANSWER: U.S. firms cannot forecast Latin American currency values accurately, because they
24. Selecting between Forecast Methods. Bolivia currently has a nominal one-year risk-free interest
rate of 40 percent, which is primarily due to the high level of expected inflation. The U.S. nominal
one-year risk-free interest rate is 8 percent. The spot rate of Bolivia’s currency (called the boliviano)
is $.14. The one-year forward rate of the boliviano is $.108. What is the forecasted percentage
change in the boliviano if the spot rate is used as a one-year forecast? What is the forecasted
percentage change in the boliviano if the one-year forward rate is used as a one-year forecast? Which
forecast do you think will be more accurate? Why?
ANSWER: The forecasted percentage change in the boliviano is zero percent based on the spot rate,
25. Comparing Market-based Forecasts. For all parts of this question, assume that interest rate parity
exists, the prevailing one-year U.S. nominal interest rate is low, and that you expect the U.S. inflation
to be low this year.
12 Forecasting Exchange Rates
a. Assume that the country Dinland engages in much trade with the U.S. and the trade involves many
different products. Dinland has had a zero trade balance with the U.S. (the value of exports and
imports is about the same) in the past. Assume that you expect a high level of inflation (perhaps
about 40%) in Dinland over the next year because of a large increase in the prices of many products
that Dinland produces. Dinland presently has a one-year risk-free interest rate of more than 40%. Do
you think that the prevailing spot rate or the one-year forward rate would result in a more accurate
forecast of Dinland’s currency (the din) one year from now? Explain.
ANSWER: The high inflation should create a shift in international trade, which will place severe
b. Assume that the country Freeland engages in much trade with the U.S. and the trade involves many
different products. Freeland has had a zero trade balance with the U.S. (the value of exports and
imports is about the same) in the past. You expect high inflation (perhaps about 40%) in Freeland
over the next year because of a large increase in the cost of land (and therefore housing) in Freeland.
You believe that the prices of products that Freeland produces will not be affected. Freeland
presently has a one-year risk-free interest rate of more than 40%. Do you think that the prevailing
one-year forward rate of Freeland’s currency (the fre) would overestimate, underestimate, or be a
reasonably accurate forecast of the spot rate one year from now? [Presume a direct quotation of the
exchange rate, so that if the forward rate underestimates, it means that its value is less than the
realized spot rate in one year. If the forward rate overestimates, it means that its value is more than
the realized spot rate in one year.]
ANSWER: The inflation in Freeland does not affect the trade balance between the U.S. and
26. IRP and Forecasting. New York Co. has agreed to pay 10 million Australian dollars (A$) in two
years for equipment that it is importing from Australia. The spot rate of the Australian dollar is $.60.
The annualized U.S. interest rate is 4%, regardless of the debt maturity. The annualized Australian
dollar interest rate is 12% regardless of the debt maturity. New York plans to hedge its exposure with
a forward contract that it will arrange today. Assume that interest rate parity exists. Determine the
amount of U.S. dollars that New York Co. will need in 2 years to make its payment.
ANSWER: The 2-year forward premium is computed as:
Forecasting Exchange Rates 13
27. Forecasting Based on the International Fisher Effect. Purdue Co. (based in the U.S.) exports
cable wire to Australian manufacturers. It invoices its product in U.S. dollars, and will not change its
price over the next year. There is intense competition between Purdue and the local cable wire
producers that are based there. Purdue’s competitors invoice their products in Australian dollars and
will not be changing their prices over the next year. The annualized risk-free interest rate is presently
8% in the U.S., versus 3% in Australia. Today the spot rate of the Australian dollar is $.55. Purdue
Co. uses this spot rate as a forecast of future exchange rate of the Australian dollar. Purdue expects
that revenue from its cable wire exports to Australia will be about $2 million over the next year.
If Purdue decides to use the international Fisher effect rather than the spot rate to forecast the
exchange rate of the Australian dollar over the next year, will its expected revenue from its exports
be higher, lower, or unaffected? Explain.
ANSWER: If IFE exists, the forecasted change in the exchange rate is :
28. IRP, Expectations, and Forecast Error. Assume that interest rate parity exists and it will
continue to exist in the future. Assume that interest rates of the U.S. and the U.K. vary substantially
in many periods. You expect that interest rates at the beginning of each month have a major effect on
the British pound’s exchange rate at the end of each month, because you believe that capital flows
between the U.S. and the U.K. influence the pound’s exchange rate. You expect that money will
flow to whichever country has the higher nominal interest rate. At the beginning of each month, you
will either use the spot rate or the one-month forward rate to forecast the future spot rate of the
pound that will exist at the end of the month. Will the use of the spot rate as a forecast result in
smaller, larger or the same mean absolute forecast error as the forward rate when forecasting the
future spot rate of the pound on a monthly basis? Explain.
ANSWER: The forward rate forecast will be poor because it will forecast depreciation when interest
29. Deriving Forecasts from Forward Rates. Assume that interest rate parity exists. Today, the one-
year U.S. interest rate is equal to 8%, while Mexico’s one-year interest rate is equal to 10%. Today,
the two-year annualized U.S. interest rate is equal to 11%, while the two-year annualized Mexican
interest rate is equal to 11%. West Virginia Co. uses the forward rate to predict the future spot rate.
Based on forward rates for one year ahead, and two years ahead, will the peso appreciate or
depreciate from the end of year 1 until the end of year 2?
ANSWER: The one-year forward rate of the peso exhibits a discount because the Mexican interest
rate exceeds the U.S. one-year interest rate. This implies that the peso will depreciate over the next
14 Forecasting Exchange Rates
30. Forecast Errors from Forward Rates. Assume that interest rate parity exists. One year ago, the
spot rate of the euro was $1.40 and the spot rate of the Japanese yen was $.01. At that time, the one–
year interest rate of the euro and Japanese yen was 3% and the one-year U.S. interest rate was 7%.
One year ago, you used the one-year forward rate of the euro to derive a forecast of the future spot
rate of the euro and the yen one year ahead. Today, the spot rate of the euro is $1.39, while the spot
rate of the yen is $.009. Which currency did you forecast more accurately?
ANSWER: FR premium of euro and yen = [(1.07)/(1.03)] -1 = .03883
31. Forward Versus Spot Rate Forecasts. Assume that interest rate parity exists and it will continue
to exist in the future. Kentucky Co. wants to forecast the value of the Japanese yen in one month.
The Japanese interest rate is lower than the U.S. interest rate. Kentucky Co. will either use the spot
rate or the one-month forward rate to forecast the future spot rate of the yen at the end of one month.
Your opinion is that net capital flows between countries tend to move toward whichever country has
the higher nominal interest rate, and that these capital flows are the primary factor that affects the
value of the currency. Will the forward rate as a forecast result in a smaller, larger or the same
absolute forecast error as the use of today’s spot rate when forecasting the future spot rate of the yen
in one month? Briefly explain.
ANSWER: Since the U.S. has a higher interest rate, investors would want to put their money in the
32. Forward Versus Spot Rate Forecast. Assume that interest rate parity exists. The one-year risk-free
interest rate in the U.S. is 3 percent, versus 16 percent in Singapore. You believe in purchasing
power parity, and you also believe that Singapore will experience a 2% inflation rate, and the U.S.
will experience a 2% inflation rate over the next year. If you wanted to forecast the Singapore
dollar’s spot rate for one year ahead, do you think that the forecast error would be smaller when
using today’s one-year forward rate of the Singapore dollar as the forecast or using today’s spot rate
as the forecast? Briefly explain.
Forecasting Exchange Rates 15
ANSWER: The spot rate should have a smaller forecast error because the spot rate would be a more
Solution to Continuing Case Problem: Blades, Inc.
1. Considering both Blades’ current practices and future plans, how can it benefit from forecasting the
baht-dollar exchange rate?
ANSWER: Blades can benefit from forecasting the baht-dollar exchange rate in various ways. First,
2. Which forecasting technique (i.e., technical, fundamental, or market-based) would be easiest to use
in forecasting the future value of the baht? Why?
ANSWER: A market-based forecast is the easiest to use. A fundamental forecast is more
3. Blades is considering using either current spot rates or available forward rates to forecast the future
value of the baht. Available forward rates currently exhibit a large discount. Do you think the spot or
the forward rate will yield a better market-based forecast? Why?
ANSWER: The forward rates will likely yield more accurate results. The forward rate of the baht
4. The current 90-day forward rate for the baht is $.021. By what percentage is the baht expected to
change over the next quarter according to a market-based forecast using the forward rate? What will
be the value of the baht in 90 days according to this forecast?
ANSWER: According to the market-based forecast, the baht is expected to change by:
16 Forecasting Exchange Rates
5. Assume that the technical forecast has been more accurate than the market-based forecast in recent
weeks. What does this indicate about market efficiency for the baht-dollar exchange rate? Do you
think this means that technical analysis will always be superior to other forecasting techniques in the
future? Why or why not?
ANSWER: A more accurate forecast using historical information than when using the spot rate as a
6. What is the expected percentage change in the value of the baht during the next quarter based on the
fundamental forecast? What is the forecasted value of the baht using this forecast? If the value of the
baht 90 days from now turns out to be $.022, which forecasting technique is the most accurate? (Use
the absolute forecast error as a percentage of the realized value to answer the last part of this
question.)
ANSWER: The expected change in the value of the baht according to the fundamental forecast is:
7. Do you think the technique you have identified in question 6 will always be the most accurate? Why
or why not?
ANSWER: No, the technical forecast will probably not always be the most accurate. First, the
Forecasting Exchange Rates 17
Solution to Supplemental Case: Whaler Publishing Co.
1. The first step is to measure the standard deviation of the percentage change in each exchange rate,
which can most easily be done with a spreadsheet. This information can then be used along with
today’s spot exchange rate to derive the confidence intervals for each exchange rate.
Using the intervals described above and the number of foreign currency units to be received from
each country, the range of forecasted U.S. dollar revenues (in thousands) from each country is
disclosed below:
68 Percent 95 Percent
Confidence Confidence
Notice that the estimates were not pooled in any way to derive a confidence interval about the overall
dollar revenues. This would require an assumption that each exchange rate moves independently of
the others. If some of these currencies were positively correlated, such an assumption would cause
one to underestimate the dispersion in the confidence interval when combining estimates from
individual countries. If time permits, you may wish to challenge the students by asking them whether
combining the individual country results would be appropriate. The supplemental case in the
following chapter focuses on this issue and is an extension of this case.
18 Forecasting Exchange Rates
Small Business Dilemma
Exchange Rate Forecasting by the Sports Exports Company
1. Explain how Jim can use technical forecasting to forecast the future value of the pound. Based on
the information provided, do you think that a technical forecast will predict future appreciation or
depreciation in the pound?
ANSWER: Jim could develop a technical forecast by reviewing historical values of the British
2. Explain how Jim can use fundamental forecasting to forecast the future value of the pound. Based on
the information provided, do you think that a fundamental forecast will predict appreciation or
depreciation in the pound?
ANSWER: Jim could develop a fundamental forecast by first developing a model that determines
3. Explain how Jim can use a market-based forecast to forecast the future value of the pound. Do you
think the market-based forecast will predict appreciation, depreciation, or no change in the value of
the pound?
ANSWER: Jim could use either the spot rate or the forward rate as a market-based forecast.
4. Does it appear that all of the forecasting techniques will lead to the same forecast of the pound’s
future value? Which technique would you prefer to use in this situation?
ANSWER: The forecast techniques do not lead to the same conclusion about the direction of the
Forecasting Exchange Rates 19