Foreign Exchange Market and Analysis
1. (a) Explain the rationale for exchange rate forecasting and the motives of global banking firms and
asset managers for forecasting exchange rates. [15 marks]
(b) Compare and contrast the technical technique for forecasting exchange rates versus the fundamental
approach to exchange rate forecasting. What are the limitations (i.e., problems) with using these
techniques to forecast exchange rates? What advantage, if any, does the time series approach have over
the technical and fundamental techniques for forecasting exchange rates? [20 marks]
(c) Financial economists at Horizon Capital believe that due to the recent surge in U.K. inflation rates
that future real interest rate movements will affect exchange rates and have applied regression analysis
to historical data to evaluate the relationship. The economists intend to use the regression coefficients
derived from their econometric analysis together with forecasted real interest rate movements in order
to forecast exchange rates in the future. Explain at least three limitations of this technique. [10 marks]
2. The currency pair of the spot CHF/$ is 1.4723, while the three-month interest rates are 1.80 per cent
for the U.S. dollar (7.2% annualized) and 0.95 per cent for the CHF (3.8% annualized).
Suppose foreign exchange market participants are risk-neutral. What is the implied market prediction
for the three-month ahead CHF/$ exchange rate? [10 marks]
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3. The efficient market approach maintains that the current spot exchange rate fully reflects all available
and relevant information. Given the following:
t t t 1 1 S S e + + = +
Develop a model to forecast the exchange rate six steps ahead. [15 marks]
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4. Given the data below on the Japanese yen to the dollar exchange rate. Each period is three months.
The spot rate is the actual exchange rate prevailing at the start of the period, while the Forward rate is
the three-month forward exchange rate prevailing at the start of a period. The forecast rate is the forecast
made by the Industrial Bank of Japan at the start of a period for the spot exchange rate at the start of the
next period (That is, the forecast for three months later).