Forecasting Exchange Rates

Forecasting Exchange Rates

PROJECT 3: The four methods for analyzing exchange rates:

- Purchasing Power Parity (PPP)

- International Fisher Effect (IFE)

- The Forward Rate

- Regression Analysis (Nelson Mark model)

The methods studied to date:

1) PPP used to forecast exchange rate movement: For 2016 inflation is forecast to rise at 2% in Canada and 0.1% in Japan.

A) Given the inflation rates described above, which currency should depreciate according to PPP (strictly applied)?

B) Given higher inflation in Canada, would you always expect the exchange rate CAD/JPY to adjust during the one-year period? This question refers to the short term and long term nature of PPP adjustment.

2) Given results in (1) and the FISHER equation: nominal i = real i + inflation, explain the nominal interest rate differential (1 yr.) you would expect to see between Canadian and Japanese rates.

3) IFE : Using (S1 – S2)/S2 = iCAD - iJAP

A) Assume : S1 = spot now ; S2 = spot in one year

B) Given your results for (2) above, according to IFE what effect should the nominal interest rate differential have on the variation of the SPOT rate over one year ?

C) Would you expect that IFE is always effective as a medium term exchange rate forecasting tool ? as a short term (1 year or less) forecasting tool ?

4) FORWARD RATE : What is your evaluation of the forward rate as a forecasting tool for the T=1 period ?