Hw chapter 9 - Professor Frega PDF

Preview

Summary

Professor Frega...

Description

Taylor Phelps Chapter 9 Questions and Applications

1. Explain corporate motives for forecasting exchange rates. Many decisions of MNC’s require an assessment of the future and future exchange rates affect these decisions, as well as costs and revenue. For example, various operations require exchange rate projections, hedging, budgeting, and earnings assessments. These operations are more effective when exchange rates are forecasted accurately. 2. Explain the technical technique for forecasting exchange rates. What are some limitations of using technical forecasting to predict exchange rates? Technical forecasting involves reviewing historical exchange rates in search of a pattern. The pattern assists in predicting future exchange rate movements. Once market participants use a technical forecasting model it is no longer valuable because currency value will move immediately rather than in the future. Technical forecasting is typically used for short-term horizons and MNC’s prefer longer term forecasts. 3. Explain the fundamental technique for forecasting exchange rates. What are some limitations of using a fundamental technique to forecast exchange rates? Fundamental forecasting is based on underlying relationships between one or more variables and a currency’s value. A change in one or more of these variables will cause a change in the forecast of the currency’s value. Even if a relationship exists, it is difficult to accurately quantify the relationship in a form that can be applied to a forecast, and it is difficult to determine the lagged impact some variables cause. 4. 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? Market-based forecasts reflect an expectation of the markets future rates. If the markets expectation differed from existing rates, the market participants should react by taking positions in various currencies until the current rate reflects the future expectation. The market determines the spot rate and forward exchange rate, therefore, these market-based rates can be used to forecast. This movement would force rates to shift toward the expectation of the future spot rate and market-based forecasts would have underestimated the realized value of the euro over this time period because the actual values were above the quoted rates. 5. Explain the mixed technique for forecasting exchange rates. Mixed forecasting uses two or more forecasting techniques. The specific combination to be used differs in terms of techniques utilized and the importance of each technique.

6. Explain how to assess performance in forecasting exchange rates. Explain how to detect a bias in forecasting exchange rates. To assess performance in forecasting exchange rates, one can calculate the absolute forecast error as a percentage of the realized value for all periods where a forecast was necessary. Then an average of this error can be calculated and compared to all currencies or forecasting models. Forecast bias results from consistently over or underestimating exchange rates. If the majority of points are above the 45º perfect forecast line, then the forecasts generally underestimate the realized values. If the majority of points are below the 45º perfect forecast line, then the forecasts generally overestimate the realized values. 7. 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. PERIO D 1 2 3 4

YEN FORECAST $.0050 .0048 .0053 .0055

ACTUAL YEN VALUE $.0051 .0052 .0052 .0056

PERIO D

CALCULATION

1 2 3 4

(0.0050-0.005)/0.0051 (0.0052-0.0048)/0.0052 (0.0052-0.0053)/0.0052 (0.0056-0.0055)/0.0056 Mean

POUND FORECAST $1.50 1.53 1.55 1.49

YEN CALCULATION FORECAST ERROR 1.961% (1.51-1.5)/1.51 7.692% (1.5-1.53)/1.5 1.923% (1.58-1.55)/1.58 .0056 1.49 3.340%

ACTUAL POUND VALUE $1.51 1.50 1.58 1.52 POUND FORECAST ERROR 0.662% 2.000% 1.899% 1.52 1.634%

8. 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. The timing of the impact of real interest rates on exchange rates may differ from what is specified by the model. The forecasted real interest rates may be inaccurate, causing inaccurate forecasts. Lastly, the model has ignored other factors that may also influence exchange rates. 9. 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? The forecasts may be inconsistent with forecasts of other currencies by other subsidiaries if each subsidiary uses its own data and techniques to forecast its local currency’s exchange

rate. Subsidiary forecasts could be consistent if forecasts for all currencies were based on complete information from all its subsidiaries. 10. Assume that the four-year annualized interest rate in the United States is 9% and the four-year annualized interest rate in Singapore is 6%. Assume interest rate parity holds for a four-year horizon. Assume that the spot rate of the Singapore dollar is $0.60. 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? Country U.S. Singapore

Four-Year Compounded Return (1.09)4 – 1 = 41% (1.06)4 – 1 = 26%

Premium: = (1+0.41) / (1+0.26) – 1 = (1.41 / 1.26) – 1 = 0.119 or 11.9% The four-year forward rate should contain an 11.9% premium above today’s spot rate of $.60, which means the forward rate is $.60 × (1 + 0.119) = $0.6714. The forecast for the Singapore dollar’s spot rate in four years is $0.6714, which represents an appreciation of 11.9% over the four-year period. 11. Assume that foreign exchange markets were found to be weak-form efficient. 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. Technical analysis should not be able to achieve excess profits if foreign exchange markets are weak-form efficient. Today’s rates do not provide information about the range of possible outcomes and MNC’s may want to assess the range of possible outcomes. 12. The director of currency forecasting at Champaign-Urbana Corp. says “The most critical task of forecasting exchange rates is not to derive a point of estimate of a future exchange rate but to asses how wrong our estimate might be.” What does this statement mean? Future forecasts of exchange rates are not going to be perfectly accurate. MNC’s that develop point estimate forecasts recognize this and are likely to determine how far off forecasts may be. They will have more confidence in forecasts of currencies that have been forecasted with only minor errors. They will practice caution in basing decision off currencies in which forecast errors may be large. 13. 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.

Fundamental forecasting typically relies on historical relationships between economic factors and exchange rate movements. However, if exchange rates were not allowed to move in the past, historical relationships will not be useful in predicting future exchange rates of such currencies. 14. Royce Co. is a US 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. The British pound’s future spot rate is more difficult to predict because of the pound’s volatility, making dollar revenues from the pound receivables more uncertain. 15. Cooper, Inc., a US 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? Cooper Inc. should use data for all countries participating in the euro, rather than exclusively using German data, as the euro’s exchange rate is affected by all transactions between euros and dollars....