Chapter 9Forecasting Exchange Rates 1. Which of the following forecasting techniques would best represent the use of today’s forward exchange rate to forecast the future exchange rate? A) fundamental forecasting. B) market-based forecasting. C) technical forecasting. D) mixed forecasting. ANSWER: B 2. Which of the following forecasting techniques would best represent sole use of today’s spot exchange rate of the euro to forecast the euro’s future exchange rate? A) fundamental forecasting. B) market-based forecasting. C) technical forecasting. D) mixed forecasting. ANSWER: B 3. Which of the following forecasting techniques would best represent the use of relationships between economic factors and exchange rate movements to forecast the future exchange rate? A) fundamental forecasting. B) market-based forecasting. C) technical forecasting. D) mixed forecasting. ANSWER: A 4. Which of the following forecasting techniques would best represent the sole use of the pattern of historical currency values of the euro to predict the euro’s future currency value? A) fundamental forecasting. B) market-based forecasting. C) technical forecasting. D) mixed forecasting. ANSWER: C 230 10 + .52 – $.40 .40 + ($. ANSWER: B 7. firms with greater accuracy than other currencies.44 – $.54 – $.02]/4 = . C) forecasted future exchange rates accurately. If a particular currency is consistently declining substantially over time.60)/$.51 Realized Value of New Zealand Dollar $.60 + ($.50)/ $. B) overestimated the future exchange rates over time. According to the text.44 .S. the analysis of currencies forecasted with use of the forward rate suggests that: A) currencies exhibited about the same mean forecast errors as a percent of the realized value.50 . ANSWER: B 6.5%. Assume the following information: Period 1 2 3 4 Predicted Value of New Zealand Dollar $. C) the Swiss franc can be forecasted by U.54 .231 International Financial Management 5.S. C) 6%. then a market-based forecast will usually have: A) underestimated the future exchange rates over time.60 . E) none of these.065 = 6. D) 6.50 Given this information. ANSWER: D SOLUTION: [($. firms with greater accuracy than other currencies.50% .50)/$.40)/$. B) 26%.51 – $.5%. B) the Canadian dollar can be forecasted by U.52 . the mean absolute forecast error as a percentage of the realized value is about: A) 1.10 + .50]/4 = [.04 + . D) none of these. D) forecasted future exchange rates inaccurately but without any bias toward consistent underestimating or overestimating.50 + ($. A) technical forecast technique B) fundamental forecast technique C) none of these D) all of these ANSWER: A 9. C) technical analysis. If it was determined that the movement of exchange rates was not related to previous exchange rate values. Which of the following is true according to the text? A) Forecasts in recent years have been very accurate. C) Forecasting errors are smaller when focused on longer term periods. ANSWER: D 10. B) Use of the absolute forecast error as a percent of the realized value is a good measure to use in detecting a forecast bias.Chapter 9: Forecasting Exchange Rates 232 8. When the value from the prior period of an influential factor affects the forecast in the future period. this implies that a _______ is not valuable for speculating on expected exchange rate movements. B) Forecast errors are negative when the forecasted rate exceeds the realized rate. D) factor analysis. Which of the following is true? A) Forecast errors cannot be negative. D) instantaneous input AND simultaneous input. C) simultaneous input. ANSWER: D 11. D) None of these are true. C) Absolute forecast errors are negative when the forecasted rate exceeds the realized rate. B) instantaneous input. this is an example of a: A) lagged input. D) None of these are true. A fundamental forecast that uses multiple values of the influential factors is an example of: A) sensitivity analysis. B) discriminant analysis. ANSWER: A 12. ANSWER: A . 752. and the inflation variable is directly related to the exchange rate. and the Mexican five-year interest rate is 8% annualized. Which of the following is true? A) The interest rate variable is inversely related to the exchange rate. then _______ would be refuted.80 × [1 + (–6%)] = $.262. B) $.226. The U.860. Assume the regression coefficient of the interest rate differential variable is –. Today’s spot rate of the Canadian dollar is $. ANSWER: E SOLUTION: (1. D) The interest rate variable is directly related to the exchange rate. Which of the following is not a limitation of fundamental forecasting? A) uncertain timing of impact.20[1 + (–13%)] = $.131. B) forecasts are needed for factors that have a lagged impact. C) $. $. E) none of these. but not all relevant private information. C) omission of other relevant factors from the model.740.20. What is the approximate five-year forecast of the peso’s spot rate if the five-year forward rate is used as a forecast? A) $. and the inflation variable is directly (positively) related to the interest rate variable. B) The interest rate variable is inversely related to the exchange rate.S. E) $. ANSWER: D SOLUTION: $. C) $. ANSWER: B 14. and the inflation variable is directly related to the interest rate variable. The forward rate of the Canadian dollar contains a 6% discount. and the coefficient of the inflation differential variable is . B) $. Assume that interest rate parity holds. Assume a forecasting model uses inflation differentials and interest rate differentials to forecast the exchange rate. ANSWER: B 15. Today’s spot rate of the Mexican peso is $. D) possible change in sensitivity of the forecasted variable to each factor over time.05)5/(1.80. and the inflation variable is directly related to the exchange rate. Assume that the forward rate is used to forecast the spot rate.752 17. If today’s exchange rate reflects all relevant public information about the euro’s exchange rate.174. D) $. The spot rate forecasted for one year ahead is: A) $.4.848.5. E) none of these. A) weak-form efficiency .140.08)5 – 1 = –13%. D) $. C) The interest rate variable is directly related to the exchange rate. five-year interest rate is 5% annualized.233 International Financial Management 13.174 16. technical forecasting. If the forward rate was expected to be an unbiased estimate of the future spot rate. C) the international Fisher effect (IFE) is refuted. interest rate is 11 percent. A) weak-form efficiency B) semistrong-form efficiency C) strong-form efficiency D) weak-form efficiency AND semistrong-form efficiency E) semistrong-form efficiency AND strong-form efficiency ANSWER: D 19. A) B) C) D) Which of the following is not a forecasting technique mentioned in the text? accounting-based forecasting. Assume interest rate parity holds. while Australia’s one-year interest rate is 12 percent. D) information on future interest rates is needed to answer this question. ANSWER: B 21. the forecast would reflect an expectation of: A) depreciation in the Australian dollar’s value over the next year. If the one-year forward rate of the Australian dollar was used to forecast the future spot rate.S. According to the text. B) the international Fisher effect (IFE) is supported. market-based forecasting.Chapter 9: Forecasting Exchange Rates B) C) D) E) semistrong-form efficiency strong-form efficiency weak-form efficiency AND semistrong-form efficiency semistrong-form efficiency AND strong-form efficiency 234 ANSWER: D 18. C) no change in the Australian dollar’s value over the next year. ANSWER: A 20. ANSWER: A . D) the average absolute error from forecasting would equal zero. research generally supports _______ in foreign exchange markets. fundamental forecasting. B) appreciation in the Australian dollar’s value over the next year. and interest rate parity holds. then: A) covered interest arbitrage is feasible. Assume that the U. Using this information.005 + (.3) + (–. However.40%. Regression results indicate coefficients of a0 = .4) + (–. C) 5. and India.04)(. B) 0.3) = –3.S.7. the interest rate differential is not known at the beginning of period t and must be estimated. The following regression model was estimated to forecast the value of the Malaysian ringgit (MYR): MYRt = a0 + a1 INCt −1 + a2 INFt −1 + µt . The following regression model was estimated by Delta Corporation to forecast the value of the Indian rupee (INR): INRt = a0 + a1 INTt + a2 INFt −1 + µt . The most recent quarterly percentage change in the inflation differential is –5%. B) –1.40%.60%. INF is the previous quarterly percentage change in the inflation differential.003 + (–.4)(. where MYR is the quarterly change in the ringgit. and INF is the inflation rate differential between the U.8. ANSWER: A SOLUTION: E [ INTt ] = (–. C) 3.4. where INR is the quarterly change in the rupee.5. D) –4.03) + (. and a2 = .003.02) = 3. E) none of these.235 International Financial Management 22.80%.70%. D) 1.05) = –1. Delta Corp.10%.03)(.5)(–. and India in the previous period.02)(. Assume that INFt −1 = 2%.60%.S.00% INRt = .40% .2%. while the most recent quarterly percentage change in the income differential is 3%. a1 = –.005. INT is the real interest rate differential in period t between the U. the forecast for the percentage change in the ringgit is: A) 4.80% 23. ANSWER: B SOLUTION: MYRt = . and INC is the previous quarterly percentage change in the income growth differential.8)(. and a2 = . E) none of these. a1 = . Regression results indicate coefficients of a0 = . has developed the following probability distribution: Probability 30% 40% 30% Possible Outcome –2% –3% –4% The expected change in the Indian rupee in period t is: A) 3.03) + (.7)(–. A) overestimated B) underestimated C) correctly estimated D) none of these ANSWER: B . Regression results reveal coefficients of a0 = 0 and a1 = 1.90% Therefore.0067 Realized Value $.34% D) Australian dollar. management believes its forecasts to be biased. Listed below are the forecasted and realized values for the last period: Currency Australian dollar Japanese yen Forecasted Value $.0069)/.19% B) Australian dollar. Thus.09% Absolute forecast error for the Japanese yen = (. Huge Corporation has just initiated a market-based forecast system using the forward rate as an estimate of the future spot rate of the Japanese yen (¥) and the Australian dollar (A$).0069 = 2. A) yen. Huge Corp. 6.Chapter 9: Forecasting Exchange Rates 236 24.19%. where St is the spot rate of the pound in year t and Ft −1 is the forward rate of the pound in year t–1. has forecasted the _______ more accurately by _______%. Gamma has reason to believe that its past forecasts have _______ the realized spot rate.3. even though the company has used a market-based forecast based on the forward rate.60 – . has estimated the Japanese yen more accurately by approximately 6. Huge Corp.55)/. 25. Gamma Corporation has incurred large losses over the last ten years due to exchange rate fluctuations of the Egyptian pound (EGP).34% E) none of these ANSWER: A SOLUTION: Absolute forecast error for the Australian dollar = (.55 $.55 = 9.60 $. The following regression model was estimated to determine if the forecasts over the last ten years were biased: St = a0 + a1Ft −1 + µt .0069 According to this information and using the absolute forecast error as a percentage of the realized value.0067 – . 5.19% C) yen. Consequently. 5. 6. A) true.8%. expedite D) none of these ANSWER: B 28. appreciate C) depreciate. If an MNC invests excess cash in a foreign county. ANSWER: A 31. Today.8% 30. A) appreciate. dollar. Using regression analysis.8%. Based on this information. depreciate B) appreciate. ANSWER: A 27.S. the Canadian dollar is expected to _______ tomorrow. today D) appreciate by . has to pay 5 million Canadian dollars for supplies it recently received from Canada.8%. the Canadian dollar has appreciated by 2 percent against the U. it experiences a reversal of 40 percent on the following day. the parent may prefer to _______ the remittance of subsidiary earnings. A) weaken. today B) depreciate by . tomorrow C) appreciate by . Sulsa Inc. Severus Co. using the volatility of historical exchange rate movements as a forecast for the future. uses fundamental forecasting. if an MNC issues bonds denominated in a foreign currency. A) B) C) D) International Financial Management Which of the following is not a method of forecasting exchange rate volatility? using the absolute forecast error as a percentage of the realized value. depreciate D) depreciate. A) depreciate by . delay B) weaken.S.8%. using a time series of volatility patterns in previous periods. it would like the foreign currency to _______. If a foreign currency is expected to _______ substantially against the parent’s currency.237 26. Corporations tend to make only limited use of technical forecasting because it typically focuses on the near future. Severus has determined that whenever the Canadian dollar appreciates against the U. deriving the exchange rate’s implied standard deviation from the currency option pricing model. which is not very helpful for developing corporate policies. appreciate ANSWER: A 29. dollar by more than 1 percent. expedite C) appreciate. tomorrow ANSWER: B SOLUTION: et +1 = (2%) × (−40%) = −0. B) false. it has determined the following equation for the euro: . it would like the foreign currency to _______. and Severus would prefer to make payment _______. Based on this information.00 C) –1.1INCt −1 238 The most recent quarterly percentage change in the inflation differential between the U.4 C) appreciation.0097 SOLUTION: 1. while the current spot rate is $1.03 C) 1. and Europe was –1 percent.07 / 1.02 B) 1.7 D) appreciation.S. If the one-year forward rate for the euro is $1.90% . A) 1.S. 3.07.03(1.0097) = $1.S.005 + . The current spot rate of the euro is $1.9(. while the most recent quarterly percentage change in the income growth differential between the U. Using purchasing power parity.04 ef = 33.005 + .04 D) none of these ANSWER: C 1.01) = 1. A) 1.04 − 1 = .05 − 1 = 1.02) + 1. A) appreciation.4 B) depreciation. 1.2 ANSWER: D SOLUTION: eurot = . inflation rate is expected to be 4 percent over the next year. 0. The U. the expected percentage change in the euro is _______%. the expected spot rate at the end of one year is $_______. the forecast for the euro is a(n) _______ of _______%.2% 32.87 D) none of these ANSWER: A SOLUTION: E (e) = 1. while the European inflation rate is expected to be 3 percent.90 B) 2.Chapter 9: Forecasting Exchange Rates eurot = bo + b INFt −1 + b2 INCt −1 = . 3. and Europe was 2 percent.05.03 E ( St +1 ) = $1.9 INFt −1 + 1.03.1(−. stable C) lower. low ANSWER: C 35. high B) spot. similar B) substantial.8% 38. A) 9. Thus. the forward rate premium or discount will be _______. Factors such as economic growth.73 − 0. A) lower. Silicon Co. the _______ rate should provide more accurate forecasts for currencies in _______-inflation countries. The realized value of the Canadian dollar in the most recent period was $0. then between the forward rate and the spot rate. in periods when the currency is more _______. International Financial Management If both interest rate parity and the international Fisher effect hold. A) spot. volatile B) higher.8 ANSWER: C SOLUTION: 0. stable D) none of these ANSWER: C . A) technical B) fundamental C) market-based D) none of these ANSWER: B 37.80. inflation.8 D) –8.6 C) 8. very different C) close to zero. If a foreign country’s interest rate is similar to the U.80 = 8.6 B) –9. low C) forward. rate. A) substantial. on average.S. the absolute forecast error as a percentage of the realized value was _______%. The absolute forecast error of a currency is _______. meaning that the forward rate and spot rate will provide _______ forecasts. similar D) close to zero. very different ANSWER: C 36.80 0. and interest rates are an integral part of _______ forecasting. has forecasted the Canadian dollar for the most recent period to be $0. high D) forward.73.239 34. B) false. A) B) C) D) Foreign exchange markets are generally found to be at least _______ efficient. the Australian dollar is expected to depreciate by . then historical and current exchange rate information is not useful for forecasting exchange rate movements. then technical forecasting is appropriate. B) false.8.S.8%. ANSWER: A 44. A) true. for every 1% increase in the inflation differential. ANSWER: B 43. 240 If the foreign exchange market is _______ efficient.S. A) true.Chapter 9: Forecasting Exchange Rates 39. If the pattern of currency values over time appears random. Thus. A) true. MNCs can forecast exchange rate volatility to determine the potential range surrounding their exchange rate forecast. weak-form semistrong-form strong form none of these ANSWER: B 41. and Australia produced a coefficient of . ANSWER: B . A regression analysis of the Australian dollar value on the inflation differential between the U. B) false. A) true. and foreign countries are examples of variables that could be used in fundamental forecasting. ANSWER: A 42. A) weak-form B) semistrong-form C) strong form D) all of these ANSWER: D 40. Inflation and interest rate differentials between the U. B) false. rather than nominal amounts. ANSWER: A . A) true. the spot rate is expected to appreciate or depreciate by the same amount as the forward premium or discount. respectively. ANSWER: A 50. A) true. B) false. A motivation for forecasting exchange rate volatility is to obtain a range surrounding the forecast. The closer graphical points are to the perfect forecast line. Research indicates that currency forecasting services almost always outperform forecasts based on the forward rate. Thus. ANSWER: A 47. ANSWER: B 48. are often used to compute forecast errors. A) true. When measuring forecast performance of different currencies. Foreign exchange markets appear to be strong-form efficient. it is often useful to adjust for their relative sizes. ANSWER: A 49. ANSWER: B 46. If the forward rate is used as an indicator of the future spot rate. A) true. B) false. The most sophisticated forecasting techniques provide consistently accurate forecasts. B) false. B) false. A) true. B) false. B) false. B) false. A) true. the better is the forecast. A) true.241 International Financial Management 45. ANSWER: B 51. percentages. Usually. ANSWER: A 59. B) false. If points are scattered evenly on both sides of the perfect forecast line. B) false. If foreign exchange markets are strong-form efficient. ANSWER: B 58. . A) true. ANSWER: B 57. A) true. B) false. is referred to as technical forecasting. A) true. B) false. Fundamental models examine moving averages over time and thus allow the development of a forecasting rule. Exchange rates one year in advance are typically forecasted with almost perfect accuracy for the major currencies. then all relevant public and private information is already reflected in today’s exchange rates. then the forecast appears to be very accurate. ANSWER: B 56. B) false. Two methods to assess exchange rate volatility are the volatility of historical exchange rate movements and the exchange rate’s implied standard deviation from the currency option pricing model. ANSWER: B 54. A) true. A) true. B) false.Chapter 9: Forecasting Exchange Rates 242 52. ANSWER: A 53. such as inflation. A) true. B) false. ANSWER: B 55. but not for currencies of smaller countries. fundamental forecasting is used for short-term forecasts. A) true. Market-based forecasting involves the use of historical exchange rate data to predict future values. while technical forecasting is used for longer-term forecasts. A) true. A forecasting technique based on fundamental relationships between economic variables and exchange rates. ANSWER: B International Financial Management 60. A) true. ANSWER: B . A) true. ANSWER: B 62. B) false. any key managerial decision that is based on forecasted exchange rates should rely completely on one forecast rather than alternative exchange rate scenarios.243 B) false. B) false. ANSWER: A 61. B) false. In general. A) true. A forecast of a currency one year in advance is typically more accurate than a forecast one week in advance since the currency reverts to equilibrium over a longer term period. The potential forecast error is larger for currencies that are more volatile.