International-Financial-Management---Bekaert-2e---Solutions---Ch10.doc

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.”However,itispossiblethatthechangeinthemoneysupplyisaccompaniedbyanincreaseinrealincomethatincreasesthedemandformoneyandthusoffsetsthemoneysupply’seffectontheexchangerate.

7.Isacurrentaccountdeficitalwaysassociatedwithastrongrealexchangerate（thatis,onethatisovervaluedcomparedtothePPPprediction）?

Answer:

Notnecessarily.Itisbesttoviewthecurrentaccountandtherealexchangerateasbeingdeterminedinanequilibriumthatdependsonmanyforces,suchasmovementsinnetforeignassets,governmentspending,productivitygrowth,andtheexpectationsandrisktolerancesofdomesticandforeigninvestors.

8.Describehowthreemacroeconomicfundamentalsaffectexchangerates.

Answer:

Accordingtothemonetaryexchangeratemodel,thedomesticcurrencyweakens（strengthens）ifthedomestic（foreign）moneysupplyincreasestodayorifnewsarrivesthatleadspeopletobelievethatthefuturedomestic（foreign）moneysupplywillincrease.Thedomesticcurrencyalsoweakensifdomesticrealincomefalls,ifforeignrealincomerises,orifnewsarrivesthatcausespeopletoexpectlowerdomesticrealgrowthorfasterforeignrealgrowth.Finally,accordingtotheequilibriumtheoryregardingtherealexchangerateandthecurrentaccount,anincreaseingovernmentspendingoradecreaseintaxesthatcausesabudgetdeficitshouldincreasetherealexchangerate（andhencelikelyalsothenominalexchangerate）.Thisisbecauseanincreaseingovernmentspendingincreasesaggregatedemandintheeconomy,whichcausestherealinterestratetorise.Theriseintheinterestratereducesinvestmentandencouragesprivatesaving.

9.Whichsimplestatisticalmodelyieldssomeofthebestexchangeratepredictionsavailable?

Whatdoesthisimplyforthevalueofmodelsofexchangeratedeterminationtomultinationalbusinesses?

Answer:

Itissurprisinglydifficulttobeattheforecastsoftherandomwalkmodel.Thismodelusesthecurrentexchangerateasthepredictorofthefutureexchangerate.Ifthismodelprovidedthebestforecast,theunbiasednesshypothesis（whichsaystheforwardrateisthebestpredictor）wouldbeviolated.Iftherewereaforwardpremiumontheforeigncurrency,theforwardratewouldbeabovetheexpectedfuturespotrate,andyouwouldwanttoselltheforeigncurrencyintheforwardmarket.

10.Whatischartism?

Answer:

Chartistsgraphicallyrecordtheactualtradinghistoryofanexchangerateandthentrytoinferpossiblefuturetrendsbasedonthatinformationalone.

11.Whatisanx%filterrule?

Answer:

Anx%rulestatesthatyoushouldgolongintheforeigncurrency（buy）aftertheforeigncurrencyhasappreciatedrelativetothedomesticcurrencybyx%aboveitsmostrecenttrough（orsupportlevel）andthatyoushouldgoshortintheforeigncurrency（sell）wheneverthecurrencyfallsx%belowitsmostrecentpeak（orresistancelevel）.Commonx%filterrulesare1%or2%.

12.Whatisamoving-averagecrossoverrule?

Answer:

Moving-averagecrossoverrulesusemovingaveragesoftheexchangeratetoindicatetradedirections.Ann-daymovingaverageisjustthesampleaverageofthelastntradingdays,includingthecurrentrate.A（y,z）moving-averagecrossoverruleusesaveragesoverashortperiod（ydays）andoveralongperiod（zdays）.Thestrategystatesthatyoushouldgolong（short）intheforeigncurrencywhentheshort-termmovingaveragecrossesthelong-termmovingaveragefrombelow（above）.Commonrulesuse1and5days（1,5）,1and20days（1,20）,and5and20days（5,20）.

13.Havecurrencytradersbeensuccessfulinexploitingtheirexchangerateforecasts?

Answer:

Whilethereexistsscantempiricalevidenceontheforecastingabilityofexchangerateforecastingservices,thenumberofactivecurrencytraders,mostlyorganizedashedgefunds,hasgrownconsiderablyoverthepastdecade.Becausemanyofthesecurrencytradersreportreturnstovariousindices,wecananalyzetheirperformance.Ifsuchfundsfailtoforecastexchangerates,theyshouldnotconsistentlyproducehighreturns!

PojarlievandLevich（2008）conductedastudyonthereturnsearnedbycurrencymanagersreportingtotheBarclayCurrencyTradersIndex（BCTI）betweenJanuary1990andDecember2006.Allofthesereturnsarereportednetoffees.Hedgefundstypicallychargeafixedfeeof2%andavariablefeeof20%ontheperformanceoverabenchmark（whichcanbezeroortheTreasurybillreturn）.Thestudyfirsttriestoestablishwhattechniquesthecurrencymanagersuse:

Dotheyusethecarrystrategy,dotheyfollowtrends,ordotheytradebasedonfundamentals?

Todoso,theinvestigatorsusehistoricaldatatocreatereturnstocarry-trade,trend-following,andfundamentalstrategiesforthemajorcurrencies,andtheyuseregressionanalysistoinvest