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Chapter 10Foreign Exchange Rate Determination and ForecastingQuestions10-1.Term Forecasting. What are the major differences between short-term and long-term forecasts for the following?Long-run forecasts may be motivated by a multinational firm’s desire to initiate a foreign investment in Japan, or perhaps to raise long-term funds denominated in Japanese yen. Or a portfolio 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 the forecast is likely to be. The forecaster will typically use annual data to display long-run trends in such economic fundamentals as Japanese inflation, growth, and the BOP. Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, or dividend for perhaps a period of three months. In this case the long-run economic fundamentals may 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 the exchange 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-term forecasts on technical analysis similar to that conducted in security analysis. They attempt to correlate exchange rate changes with various other variables, regardless of whether there is any economic rationale for the correlation. The chances of these forecasts being consistently useful or profitable depends on whether one believes the foreign exchange market is efficient. The more efficient the market is, the more likely it is that exchange rates are “random walks,” with past price behavior providing no clues to the future. The less efficient the foreign exchange market is, the better the chance that forecasters may get lucky and find a key relationship that holds, at least for the short run. If the relationship is really consistent, however, others will soon discover it and the market will become efficient again with respect to that piece of information. Exhibit 10.9 summarizes the various forecasting periods, regimes, and the authors’ opinions on the preferred methodologies.10-2.Exchange Rate Dynamics. What is meant by the term “overshooting”? What causes it and how is it corrected?Assume that the current spot rate between the dollar and the euro, as illustrated in Exhibit 10.9 in the text, is S0. The U.S. Federal Reserve announces an expansionary monetary policy that cuts U.S. dollar interest rates. If euro-denominated interest rates remain unchanged, the new spot rate expected by the exchange markets on the basis of interest differentials is S1. This immediate change in the exchange rate is typical of how the markets react to news,distinct economic and political events which are observable. The immediate change in the value of the dollar/euro is therefore based on interest differentials.