The hand-in date for the assignment is MONDAY, 6 FEBRUARY 2023
Answer all questions in the order indicated below. The marks for each question are as stated.
To obtain full marks, show all calculations in detail.
Dr E. Dockery

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]

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]

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).
   To illustrate, at the beginning of the third period, the actual spot exchange rate was 152.750, the threemonth ahead forward rate was 153.600, and the rate forecast by the Industrial Bank for the start of the
   fourth period was 151. The actual spot exchange rate that was realized at the start of the fourth period
   was 149.400.
   2
   (a) Based on the root mean squared error, was the Industrial Bank of Japan able to outperform the
   forward rate (Hint, calculate the percentage forecast error)? [5 marks]
   (b) You are informed that the spot rate realized three months after the last forecast given in the table
   below was 139.25. Hence, forecast the spot exchange rate. [25 marks]

Period Spot rate Forward rate Forecast rate

1 143.164 142.511 140
2 144.300 143.968 141
3 152.750 153.600 151
4 149.400 149.400 143
5 129.600 129.700 130
6 129.500 129.800 131

Note:
1 1
1
[ ( | )] t t t
t
t
S E S
S


• +
  +

− 

and
1
[ ] t t
t
t
S F
e
S

+ −

respectively