Exchange Rate Determination and Forecasting Answer Key

International Financial Management Exchange Rate Determination and Forecasting Multiple Choice Easy 1) The decomposition of the nominal interest rate into the sum of the expected real interest rate and the expected rate of inflation is known as the A) Fisher Effect. B) Siegel Paradox. C) bid-ask spread. D) exchange rate pass-through. Answer: A 2) The Fisher Effect decomposes nominal interest rates into the ________ and the expected rate of inflation. A) expected real exchange rate B) expected real interest rate C) expected forward rate of return D) nominal exchange rate Answer: B 3) The covered interest rate parity, uncovered interest rate parity, and purchasing power parity, together with the Fisher hypothesis are often referred to as the A) determinants of expected nominal exchange rates. B) determinants of expected nominal interest rates. C) international parity conditions. D) international arbitrage conditions. Answer: C 4) A higher nominal interest rate in one country indicates the fact that the country's currency was expected to ________. A) appreciate B) evaluate C) devalue D) depreciate Answer: D 5) In the short run, equality of interest rates across country boundaries is ________. A) unlikely B) a good description of reality C) a good description of purchasing power parity D) a result of stable foreign currency markets Answer: A 6) ________ techniques are typically based on formal economic models of exchange rate determination. A) Technical analysis B) Fundamental analysis C) Exchange rate forecasting D) Mean absolute error Answer: B 7) What currency forecasting technique links exchange rates to macroeconomic variables such as money supply and inflation? A) technical analysis B) fundamental analysis C) exchange rate forecasting D) mean absolute error Answer: B 8) A summary statistical measure frequently used when forecasting exchange rates is known as the A) standard deviation. B) mean. C) mean absolute error. D) mode. Answer: C 9) This statistic is calculated by taking the square root of the average squared forecast errors. A) the mean absolute error B) the standard deviation C) the mode D) the root mean squared error Answer: D 10) If a country has a capital account ________, it is ________ net foreign assets. A) deficit, acquiring B) deficit, losing C) surplus, acquiring D) surplus, in equilibrium as far as its Answer: A 11) If a country has a capital account ________, it is ________ net foreign assets. A) surplus, acquiring B) deficit, losing C) surplus, losing D) surplus, in equilibrium as far as its Answer: C 12) Whereas other forecasters use macroeconomic data to forecast future exchange rates, ________ techniques focus entirely on historical financial data. A) equilibrium condition B) parity condition C) rational expectations D) technical analysis Answer: D 13) To make predictions regarding fixed exchange rate systems and devaluations, forecasters may employ A) macroeconomic information. B) financial information. C) interest rate differentials. D) macroeconomic, financial and even interest rate differentials. Answer: D 14) Two of the most often used determinants of exchange rates are ________. A) real interest rate differentials and current account balances B) nominal interest rates and current account balances C) real interest rate differentials and real price levels D) nominal interest rate and inflation rate differentials Answer: A 15) The following three conditions together with the Fisher Hypothesis refer to as the international parity conditions EXCEPT: A) covered interest rate parity. B) nominal interest rate parity. C) purchasing power parity. D) uncovered interest rate parity. Answer: B 16) If expected real interest rates are similar across countries, countries with ________ expected inflation rates will have ________ nominal interest rates, and countries with ________ expected inflation rates will have ________ nominal interest rates. A) high, high, high, low B) high, low, high, low C) low, high, low, high D) high, high, low, low Answer: D 17) All things considered, it is unlikely that equality of real interest rates across countries is a good description of reality, especially in the short run. The following options explain the reasons for this EXCEPT: A) identical nominal returns imply very different real returns for investors in different countries. B) returns in different currencies can have different currency risk premiums. C) political risks or the threat of capital controls prevent investors from taking advantage of higher returns in other countries. D) PPP deviations are not sizable and prolonged. Answer: D 18) Which of the following forecasting techniques is typically based on formal economic models of exchange determination, which link exchange rates to money supply, inflation rates, productivity growth rates, and the current account? A) market-based forecasts B) fundamental analysis C) technical analysis D) statistical analysis Answer: B 19) Which of the following forecasting techniques is usually used for short-term forecasts using only past exchange rate data, and some other data such as the volume of currency trade, to predict future exchange rates? A) market-based forecasts B) fundamental analysis C) technical analysis D) statistical analysis Answer: C 20) Which of the following options is NOT a correct reason to why discuss technical analysis? A) Forex dealers make extensive use of technical analysis. B) The forward rate may not be an unbiased predictor of the future spot rate, even in an efficient market. C) If a sufficiently large segment of the trading world is using technical analysis, demands and supplies to trade currencies will be buffeted by these traders even if they are irrational. D) The variables on the fundamental analysis as well as the macroeconomic inputs are all available at frequent intervals. Answer: D 21) What technical forecasting method is NOT a component of statistical analysis? A) chartism B) filter rules C) regression analysis D) nonlinear analysis Answer: A Multiple Choice Moderate 1) If all of the parity conditions hold, then a real interest rate in the U.S. of 5% should be equal to ________ in another country when 3% inflation is expected in the U.S. A) 2% B) 5% C) 8% D) 15% Answer: B 2) Why would technical analysis to forecast future exchange rates be ineffective if all parity conditions prevailed? A) The best predictor of future rates would be the current spot rates. B) The only predictor would be the volatility of future exchange rates. C) The best predictor of future rates would be the forward rate. D) The unbiased predictor would not exist due to market trends. Answer: C 3) Which of the following statistics would NOT be useful to forecast currency exchange rates? A) the root mean square error B) mean absolute deviation C) the Sharpe ratio D) the covariance with the benchmark currency changes Answer: D 4) Which of the following is one of the forces that determine the equilibrium between the current account and the real exchange rate? A) movements in net foreign assets B) changes in inventories inside the economy C) the net change in the merchandise account D) the balance of trade deficit Answer: A Short Answer 1) If we assume that the international parity conditions all hold and Spain has a higher nominal interest rate than the United States, what implications does this suggest relative to inflation and its exchange rate for Spain's economy? Answer: When all the parity conditions hold, real interest rates are equalized across countries, so the country's real interest rate should equal that of the United States. The country's higher nominal interest rate therefore must reflect a higher expected rate of inflation relative to the United States. Since the parity conditions hold, a higher expected rate of inflation implies that country's currency should be expected to depreciate relative to the dollar, and the currency will trade at a forward discount relative to the dollar. 2) Which of the two types of exchange rate analyses emphasizes the use of past exchange rate data and how is it used? Answer: Fundamental analysis typically uses formal economic models of exchange rate determination and macroeconomic fundamental data such as money supplies, inflation rates, productivity growth rates, and the current account to predict exchange rates. Technical analysis uses only past exchange rate data, and perhaps some other financial data, such as the volume of currency trade, to predict future exchange rates. 3) Why would technical analysis not be useful if the international parity conditions held? Answer: If the parity conditions held, technical analysis would not be useful in the sense of providing profitable trading information or information about expected exchange rates that could not be obtained elsewhere. If the parity conditions held, the best predictor of the future exchange rate would be the forward rate, and exchange rate forecasts based on other indicators would not lead to systematic profits on currency speculation. 4) Describe three statistics you should obtain from a currency-forecasting service in order to judge the quality of its currency forecasts. Answer: Three important statistics are the Root Mean Squared Error (RMSE) or Mean Absolute Deviation of its forecasting record, which would provide information on accuracy; the percentage of times they were on the correct side of the forward rate, which would provide useful information on the profitability, and a risk—return statistic (such as the Sharpe ratio), which would provide a characterization of the profitability of using their forecasts in a real time trading strategy. 5) Describe how the macroeconomic fundamental, money supply, affects exchange rates. Answer: According to the monetary exchange rate model, the domestic currency weakens (strengthens) if the domestic (foreign) money supply increases today or if news arrives that leads people to believe that the future domestic (foreign) money supply will increase. Essay 1) Construct a list of a country's economic statistics you would assemble to help determine the probability of a devaluation of its currency within the coming year. Answer: Based on theoretical and empirical work, the following economic variables should prove useful predictors: PPP-based measures of currency overvaluation, current account balances and monetary growth rates. In addition, if liquid financial markets exist, information about forward rates or interest rates, currency option prices, and so on may prove useful in terms of forecasting devaluations. 2) In late December 1990, one-year German Treasury bills yielded 9.1%, whereas one-year U.S. Treasury bills yielded 6.9%. At the same time, the inflation rate during 1990 was 6.3% in the U.S., double the German rate of 3.1%. Were these inflation and interest rates consistent with the Fisher Effect? inflation. If Answer: They are not consistent is one assumes that future inflation will equal past that were the case, the real interest rate in Germany would probably be 6% (9.1% - 3.1%) and in the United States it would be 0.6% (6.9% - 6.3%). What was probably happening was that the markets were anticipating a fall in the U.S. inflation and a rise in German inflation. If so, then the rates are consistent with the Fisher Effect, which states that nominal interest rates are based on expected, not past inflation.