International-Financial-Management---Bekaert-2e---

©2012PearsonEducation,Inc.Chapter10ExchangeRateDeterminationandForecastingQUESTIONS1.Whatisthedifferencebetweentheexanteandtheexpostrealinterestrate?Answer:Theexpostinterestratecorrectsthenominalinterestratewiththerealizedorexpostrateofinflation;whereastheex-ante(orexpected)realinterestratecorrectsthenominalinterestrateforexpectedinflation.Asalender,youcareabouttherealreturnonyourinvestment,whichisthereturnthatmeasuresyourincreaseinpurchasingpowerbetweentwoperiodsoftime.Ifyouinvest$1,yousacrifice$1P(t)realgoodsnow,whereP(t)isthepricelevel.In1year,yougetback1+iP(t+1),whereiisthenominalrateofinterest.Wecalculatetherealreturnbydividingtherealamountyougetbackbytherealamountthatyouinvest.Thus,ifrepistheexpostrealrateofreturnandexpostrealinterestrate,wehaveep1+i1+iP(t+1)1+r==1P(t+1)P(t)P(t)NoticethattherealrateofinterestdependsontherealizationoftherateofinflationbecauseP(t+1)/P(t)=1+π(t+1),whereπ(t+1)istherateofinflationbetweentimetandt+1.Forsimplicity,wedropthetimenotationandsimplywriteep(1+i)1+r=(1+π)Ifwesubtract1fromeachside,wehaveep(1+i)(1+π)i-πr=-=(1+π)(1+π)(1+π)whichisoftenapproximatedasrep=i–πChapter10:ExchangeRateDeterminationandForecasting©2012PearsonEducation,Inc.2Theapproximationinvolvesignoringtheterm(1+π)inthedenominator,whichiscloseto1ifinflationisnottoohigh.Thus,theexpostrealinterestrateequalsthenominalinterestrateminustheactualrateofinflation.Becausetheinflationrateisuncertainatthetimeaninvestmentismade,thelendercannotknowwithcertaintytherealrateofreturnontheloan.Bytakingtheexpectedvalueofbothsidesoftheequation,conditionalontheinformationsetatthetimeoftheloan,wederivethelender’sexpectedrealrateofreturn,whichisalsocalledtheexpectedrealinterestrate,ortheexanterealinterestrate,whichwedenotere:eepttr=E[r]=i(t)-E[π(t+1)]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.Chapter10:ExchangeRateDeterminationandForecasting©2012PearsonEducation,Inc.35.Describethreestatisticsyoushouldobtainfromacurrency-forecastingserviceinordertojudgethequalityofitscurrencyforecasts.Answer:ThreeimportantstatisticsaretheRootMeanSquaredError(RMSE)orMeanAbsoluteDeviationofitsforecastingrecord,whichwouldprovideinformationonaccuracy;thepercentageoftimestheywereonthecorrectsideoftheforwardrate,whichwouldprovideusefulinformationontheprofitability,andarisk–returnstatistic(suchastheSharperatio),whichwouldprovideacharacterizationoftheprofitabilityofusingtheirforecastsinarealtimetradingstrategy.6.Doesalargeincreaseinthedomesticmoneysupplyalwaysleadtoadepreciationofthecurrency?Answer:Mosttheoriesofthedeterminationofexchangerateswouldpredictthatalargeincreaseinthemoneysupplywouldimplyadepreciationofthecurrency,definitelyinthelongrun,andespeciallyaseconomistssaywhen“everythingelseisequal.”However,itispossiblethatthechangeinthemoneysupplyisaccompaniedbyanincreaseinrealincomethatincreasesthedemandformoneyandthusoffsetsthemoneysupply’seffectontheexchangerate.7.Isacurrentaccountdeficitalwaysassociatedwithastrongrealexchangerate(thatis,onethatisovervaluedcomparedtothePPPprediction)?Answer:Notnecessarily.Itisbesttoviewthecurrentaccountandtherealexchangerateasbeingdeterminedinanequilibriumthatdependsonmanyforces,suchasmovementsinnetforeignassets,governmentspending,productivitygrowth,andtheexpectationsandrisktolerancesofdomesticandforeigninvestors.8.Describehowthreemacroeconomicfundamentalsaffectexchangerates.