Review for International Finance Exam 2

Explain the fundamental technique used in forecasting exchange rates. What are some limitations of using the fundamental technique to forecast exchange rates?

According to Chapter 9, fundamental forecasting is based on the fundamental relationships between economic variables (such as inflation, income level, and interest rates) and exchange rates. Some limitations include: 1. timing. The impact of some factors in currency's value is not known which lead to inaccuracy of exchange rate projects that prevent the predictions of future values. 2. Unknown (unquantifiable) some factors can not be easily quantified; negatively influential events that put downward pressure on foreign currencies, are not incorporated in a forecasting model.

Explain the technical technique for forecasting exchange rates. What are some limitations of using the fundamental technique to forecasting exchange rates?

According to Chapter 9, technical forecasting involves the use of historical exchange rate data, to identify patterns and predict future values of exchange rates. Some limitations include: conductions of short-term time horizons which limit formulation future corporate policies, technical forecasting techniques vary based period, and technical forecasting is will not be able to improve today's exchange rates when forecasting rates in the near future

Explain the motives of forecasting exchange rates

According to chapter 9, the motives are distinguished according to whether they can enhance the MNC's value by influencing cash flows. The motives listed in Chapter 9: hedging decision, short-term investment decision, capital budgeting decision, earnings assessment, and long-term finance decisions. If firm's use these motives, their decisions they make will be more effective based off their increase accuracy of exchange rates.

Currencies of some Latin American countries frequently weaken against most other countries. What concept in this chapter explains this occurrence? Why don't all U.S. based MNCs use forward contracts to hedge future funds from Latin American countries to the United States if they expect depreciation of the currencies against the dollar?

According to the PPP theory, countries that have high inflation will depreciate against the U.S. dollar to keep purchasing power across countries. The highly-inflated countries discourages demand for Latin American imports; downward pressure is placed on Latin American currencies. Interest rate parity forces forward rates to contain a large discount due to high interest rates in Latin America; creates a disadvantage in hedging currencies. Hedging would make greater sense if the depreciation exceed the forward discount

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 the forecasted real interest rate movements to predict exchange rates in the future. Explain at least three limitations of this method?

As discussed one of the previous questions. First, the timing of the impact of the real interest rate on exchange rates may differ from what is specified in the model. Second, the forecasted real interest rates may be not accurate, causing inaccurate forecasts of the exchange rate. Third, the sensitivity of exchange rates to real interest rate movements may change in the future (differ from what was determined when using historical data). Fourth, the model may ignore other facts that might influence exchange rates.

If technical forecasting is used, will this result in a forecast of appreciation, depreciation, or no change in any Latin American currency? Explain

Because Latin American countries have declined consistently in the past, technical forecasting would result in depreciation. Technical forecasting involves the use of historical trends to predict future data.

Explain the mixed technique of forecasting exchange rates.

Because no single forecasting technique has been found to be consistently superior to the others, some MNCs prefer to use a combination of forecasting techniques i.e. mixed forecasting. The specific combination of techniques can differ in the terms of techniques included, currency involved, and the weight of importance (that total to 100%) assigned to each technique. The techniques considered more reliable are to be assigned higher weights. The actual forecast currency is the weighted averages of the various forecasts developed.

Do you think that U.S. firms can accurately forecast the future vales of Latin American currencies? Explain

It depends. On one note, U.S. firms cannot forecast Latin American currency values accurately, because they are so volatile. Latin American currencies, or any currencies in general, constantly change in response to economic/political conditions occurring around the world. However, firms can get a closer accuracy by using the purchasing power parity, specifically the relative-form of the purchasing power parity, to estimate how the exchange rate will change in response to differential inflation rates in countries.

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.

Market-based forecasting should reflect an explanation of the market on future rates. If the market's expectation differed, then market participants should react by taking positions in various currencies until the current rates reflect an expectation of the future. The market determines the spot exchange rate and forward exchange rate. These market-based rates can be used to forecast since if they were not good indicators of the future rates, speculators would take positions. This speculative movement would force the rates to gravitate toward the expectation of the future spot rate. Market-based forecasts would have underestimated the realized values of the euro over this period because the actual values were above the spot rates and forward rates quoted earlier.

Explain the theory of the purchasing power parity (PPP). Based on this theory, what is the general forecast of the values of the currency with high inflation.

PPP specifies a precise relationship between the relative inflation rates of two countries and their exchange rate. PPP theory suggests that the equilibrium exchange rate will adjust by the same magnitude as the difference between the two countries inflation rates. For the general forecast, when a countries inflation rate rises, the demand for currency declines as its exports decline (because of higher prices). In addition, consumers and firms in that country tend to increase their importing. Both forces place downward pressure on highly-inflated currency.

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 not to assess how wrong our estimate might be." What does this statement mean?

Regardless of which method is used or which service is hired to forecast exchange rates, it is important to recognize that forecasting exchange rates are rarely perfect. MNCs that develop point estimate forecasts recognize this, but will still like to determine how off the forecast estimate might be. They would have more confidence to forecasts currencies with minor errors. For larger erroneous forecasts of currencies, MNC's should be careful placing policy decisions based off these erroneous forecasts.

Explain why the PPP theory does not hold

The PPP theory does not hold consistently because there are other factors besides inflation that influences exchange rates. Thus, exchange rates will not move in correlation with inflation differences. There may not be substitutes for traded goods. When a country's inflation increases, there foreign demand for foreign demand for its products will not always decrease if substitutes are not available.

If the forward rate is used as a market-based forecast, will this rate result in a change in forecast of appreciation, depreciation, or no change in any Latin American currency? Explain.

The forward rate of each Latin America currency would have large discount, thus highly depreciated Latin American interest rate in this case would be much higher than U.S. interest. The larger discount would serve to forecast the percentage change in the value of Latin American currency over the length of time represented in a forward contract period.

Explain the rationale behind the PPP theory

When inflation is high in a particular country, foreign demand for goods in that country will decrease. In addition, that country's demand for foreign goods should increase. Thus the home currency of that country will weaken; and will continue to weaken until the foreign country's good is no more attractive than the foreign country's goods. Differences in inflation are offset by exchange rates.