International-Financial-Management---Bekaert-2e---Solutions---Ch10.doc
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International-Financial-Management---Bekaert-2e---Solutions---Ch10.doc
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11
Chapter10:
ExchangeRateDeterminationandForecasting
Chapter 10
ExchangeRateDeterminationandForecasting
QUESTIONS
1.Whatisthedifferencebetweentheexanteandtheexpostrealinterestrate?
Answer:
Theexpostinterestratecorrectsthenominalinterestratewiththerealizedorexpostrateofinflation;whereastheex-ante(orexpected)realinterestratecorrectsthenominalinterestrateforexpectedinflation.
Asalender,youcareabouttherealreturnonyourinvestment,whichisthereturnthatmeasuresyourincreaseinpurchasingpowerbetweentwoperiodsoftime.Ifyouinvest$1,yousacrificerealgoodsnow,whereP(t)isthepricelevel.In1year,yougetback,whereiisthenominalrateofinterest.Wecalculatetherealreturnbydividingtherealamountyougetbackbytherealamountthatyouinvest.Thus,ifrepistheexpostrealrateofreturnandexpostrealinterestrate,wehave
NoticethattherealrateofinterestdependsontherealizationoftherateofinflationbecauseP(t+1)/P(t)=1+π(t+1),whereπ(t+1)istherateofinflationbetweentimetandt+1.Forsimplicity,wedropthetimenotationandsimplywrite
Ifwesubtract1fromeachside,wehave
whichisoftenapproximatedas
rep=i–π
Theapproximationinvolvesignoringtheterm(1+π)inthedenominator,whichiscloseto1ifinflationisnottoohigh.Thus,theexpostrealinterestrateequalsthenominalinterestrateminustheactualrateofinflation.
Becausetheinflationrateisuncertainatthetimeaninvestmentismade,thelendercannotknowwithcertaintytherealrateofreturnontheloan.Bytakingtheexpectedvalueofbothsidesoftheequation,conditionalontheinformationsetatthetimeoftheloan,wederivethelender’sexpectedrealrateofreturn,whichisalsocalledtheexpectedrealinterestrate,ortheexanterealinterestrate,whichwedenotere:
2.SupposethattheinternationalparityconditionsallholdandacountryhasahighernominalinterestratethantheUnitedStates.Characterizethecountry’sinflationratecomparedtotheUnitedStates,thecountry’sexpectedexchangeratechangeversusthedollar,thecountry’scurrencyforwardpremium(ordiscount)versusthedollar,andthecountry’srealinterestratecomparedtotheU.S.realinterestrate.
Answer:
Whenalltheparityconditionshold,realinterestratesareequalizedacrosscountries,sothecountry’srealinterestrateshouldequalthatoftheUnitedStates.Thecountry’shighernominalinterestratethereforemustreflectahigherexpectedrateofinflationrelativetotheUnitedStates.Sincetheparityconditionshold,ahigherexpectedrateofinflationimpliesthatcountry’scurrencyshouldbeexpectedtodepreciaterelativetothedollar,andthecurrencywilltradeataforwarddiscountrelativetothedollar.
3.Howdofundamentalanalysisandtechnicalanalysisdiffer?
Answer:
Fundamentalanalysistypicallyusesformaleconomicmodelsofexchangeratedeterminationandmacroeconomicfundamentaldatasuchasmoneysupplies,inflationrates,productivitygrowthrates,andthecurrentaccountofthebalanceofpaymentstopredictexchangerates.Technicalanalysisusesonlypastexchangeratedata,andperhapssomeotherfinancialdata,suchasthevolumeofcurrencytrade,topredictfutureexchangerates.
4.Wouldtechnicalanalysisbeusefuliftheinternationalparityconditionsheld?
Whyorwhynot?
Answer:
Iftheparityconditionsheld,technicalanalysiswouldnotbeusefulinthesenseofprovidingprofitabletradinginformationorinformationaboutexpectedexchangeratesthatcouldnotbeobtainedelsewhere.Iftheparityconditionsheld,thebestpredictorofthefutureexchangeratewouldbetheforwardrate,andexchangerateforecastsbasedonotherindicatorswouldnotleadtosystematicprofitsoncurrencyspeculation.
5.Describethreestatisticsyoushouldobtainfromacurrency-forecastingserviceinordertojudgethequalityofitscurrencyforecasts.
Answer:
ThreeimportantstatisticsaretheRootMeanSquaredError(RMSE)orMeanAbsoluteDeviationofitsforecastingrecord,whichwouldprovideinformationonaccuracy;thepercentageoftimestheywereonthecorrectsideoftheforwardrate,whichwouldprovideusefulinformationontheprofitability,andarisk–returnstatistic(suchastheSharperatio),whichwouldprovideacharacterizationoftheprofitabilityofusingtheirforecastsinarealtimetradingstrategy.
6.Doesalargeincreaseinthedomesticmoneysupplyalwaysleadtoadepreciationofthecurrency?
Answer:
Mosttheoriesofthedeterminationofexchangerateswouldpredictthatalargeincreaseinthemoneysupplywouldimplyadepreciationofthecurrency,definitelyinthelongrun,andespeciallyaseconomistssaywhen“everythingelseisequal
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