M10_EITE1342_12E_IM_C10 - Chapter 10 Foreign Exchange Rate...

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Chapter 10Foreign Exchange Rate Determinationand ForecastingQuestions10-1.Term Forecasting.What are the major differences between short-term and long-term forecastsfor the following?Long-run forecasts may be motivated by a multinational firm’s desire to initiate a foreigninvestment in Japan, or perhaps to raise long-term funds denominated in Japanese yen. Or aportfolio manager may be considering diversifying for the long term in Japanese securities.The longer the time horizon of the forecast, the more inaccurate but also the less critical theforecast is likely to be. The forecaster will typically use annual data to display long-run trendsin such economic fundamentals as Japanese inflation, growth, and the BOP.Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, ordividend for perhaps a period of three months. In this case the long-run economic fundamentalsmay not be as important as technical factors in the marketplace, government intervention, news,and passing whims of traders and investors. Accuracy of the forecast is critical since most of theexchange rate changes are relatively small even though the day-to-day volatility may be high.Forecasting services normally undertake fundamental economic analysis for long-term forecasts,and some base their short-term forecasts on the same basic model. Others base their short-termforecasts on technical analysis similar to that conducted in security analysis. They attempt tocorrelate exchange rate changes with various other variables, regardless of whether there is anyeconomic rationale for the correlation. The chances of these forecasts being consistently useful orprofitable depends on whether one believes the foreign exchange market is efficient. The moreefficient the market is, the more likely it is that exchange rates are “random walks,” with past pricebehavior providing no clues to the future. The less efficient the foreign exchange market is, thebetter the chance that forecasters may get lucky and find a key relationship that holds, at leastfor the short run. If the relationship is really consistent, however, others will soon discover it andthe market will become efficient again with respect to that piece of information. Exhibit 10.9summarizes the various forecasting periods, regimes, and the authors’ opinions on the preferredmethodologies.
10-2.Exchange Rate Dynamics.What is meant by the term “overshooting”? What causes it and how isit corrected?

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