Chapter 3

Foreign Exchange Determination

and Forecasting
Note: In the sixth edition of Global Investments, the exchange rate quotation symbols differ from previous
editions. We adopted the convention that the first currency is the quoted currency in terms of units
of the second currency.
For example, :$ = 1.4 indicates that one euro is priced at 1.4 dollars. In previous editions we used
the reversed convention $/ = 1.4, meaning 1.4 dollars per euro.
All problems in this test bank still use the old convention and have not been adapted to reflect the
new quotation symbols used in the 6th edition.
Questions and Problems
1. In 1995, the Thai baht is pegged to a basket of currencies. Assume that the baht exchange rate is set
at 25 baht per U.S. dollar. Thailand is experiencing rapid economic growth, with extensive ongoing
foreign investment. Consumer price index (CPI) inflation in Thailand is somewhat higher than in the
United States, and the current account in Thailand is in deficit. Nevertheless, Thailand has no
problem maintaining its fixed exchange rate with the dollar.
a. Explain why the Thai baht does not depreciate as suggested by purchasing power parity (PPP).
b. Two years later, prospects for economic growth are much lower and investors are worried about
the political and financial uncertainties in Thailand. Explain why the Thai baht depreciates
strongly against the U.S. dollar.
Solution
a. PPP does not take into account Thailands important growth potential. As suggested by the asset
market approach, this growth potential attracts large inflows of capital through foreign investment
in the country. This results in an increased demand for the home currency, which is consequently
strengthened. The current account deficit is offset by a financial account surplus. Also, productivity
gains in Thailand allow it to sustain a real appreciation of the baht. Both reasons explain why the
Thai baht does not depreciate as suggested by PPP.
b. Two years later, prospects for economic growth are much lower. Moreover, investors are worried
about the political and financial uncertainties in Thailand. As a result, the demand for the home
currency falls. Then, the spot exchange rate adjusts to inflation differential between the two countries.
This explains why the Thai baht depreciates against the U.S. dollar.
2. In the 1970s, France had a dual exchange rate system in place for its residents. All business trade
transactions took place at the official, or commercial, exchange rate (say, 5 francs per U.S. dollar).
All foreign investments by French industrial corporations were subject to prior government authorization.
The regulation was even stricter for French financial institutions or private residents. They were not
allowed to transfer currency abroad. French tourists could not take abroad more than FF 5,000 (or its
equivalent in foreign currency) per year. French residents could buy foreign securities, but had to use
20 Solnik/McLeavey Global Investments, Sixth Edition
a special financial rate to purchase these foreign currencies. Basically, the supply of foreign currency
assigned to financial francs was fixed. To buy foreign securities, residents had to use the proceeds
of the sales of foreign securities by other French residents. This led to a separate market for the
financial franc with a different exchange rate. Foreign income and dividends paid were repatriated
at the commercial franc rate and did not increase the supply of financial currency available. By
contrast, foreigners were free to buy and sell French securities at the commercial rate, but they
were not allowed to borrow francs.
a. Explain why this type of control imposed on French residents helps defend the French franc,
which was periodically under devaluation pressure.
b. Would you expect the financial exchange rate to be higher or lower than the commercial rate?
Solution
a. These controls made speculation against the French franc less attractive for residents. They
would have to pay a premium if they wanted to buy foreign currencies, using a financial rate
that would be higher than the commercial rate. With the supply of foreign currency assigned to
financial francs being fixed, there was indeed no possibility for any speculation against the
French franc on the part of residents. On the other side, foreigner speculation strategies were
reduced by the fact that they could not borrow francs.
b. The financial franc exchange rate (e.g., 6 francs per dollar) is likely to be higher than the commercial
franc exchange rate (e.g., 5 francs per dollar). Controls make it difficult to buy foreign-currency
securities and the supply of financial francs is fixed, while the demand for foreign investment
grows over time with general growth. The difference between the two rates is likely to increase
in periods where the franc is under speculative attacks.
3. In the early 1990s, France and Germany had similar current and forecasted inflation rates. However,
political/economic uncertainties were higher in France, where several political changes in the 1980s
had led to several devaluations of the French franc. Do you expect to observe equal interest rates in
the two countries? Why or why not?
Solution
Due to political uncertainties, investors are more likely to fear devaluations in France than in Germany.
As a result, they would rather invest their capital in Germany than in France. This supply of Deutsche
marks should lower German interest rates relative to French franc interest rates. The real interest rates
in France would be higher than in Germany to reflect the devaluation risk. Another way to say it, is
that France needs to have higher interest rates to retain capital.
4. The euro was introduced in 1999 as the common currency of eleven European countries (Euroland).
What should happen to the inflation rates of France, Germany, and Italy after the introduction of the
common currency?
Solution
Euroland has a common currency and central bank. Inflation rates across countries have to converge.
A similar argument can be applied across the various states of the United States. However, inflation
rates need not be identical across Euroland, just as they are not identical across the United States. Inflation
divergences cannot become very large though, because some physical transactions could take place to
take advantage of those. Residents of one country could move to another, production could move
across borders, and so forth. Furthermore, the European Union can impose sanctions to countries
whose inflation rate becomes too high.
Chapter 3 Foreign Exchange Determination and Forecasting 21
5. Assume that foreign exchange rates are totally unpredictable, as some theories and empirical studies
claim, so that the best prediction of the future spot rate is the current spot rate.
a. Back in 1982, would you have suggested investing in U.S. dollar bills or in German bills?
b. What about in 1992?
c. What about in 1997?
(Look at Exhibit 3.1 of the fifth edition, knowing that inflation rates were similar in the two countries.)
Solution
The best prediction of the future spot rate being the current spot rate, our forecast is that spot rates
will remain unchanged over time. The exchange rate itself will therefore remain unchanged, and we
will invest in the currency bearing the higher nominal interest rate. Since inflation rates are similar in
the two countries, this comes down to choosing the country with the higher real interest rate:
a. United States in 1982.
b. Germany in 1992.
c. United States in 1997.
6. In late 1994, it was announced that Japans monthly current account was shrinking and that this effect
could be permanent. Is this news good or bad for the Japanese yen? Why?
Solution
The permanent reduction of the monthly current account surplus of Japan is bad news for the home
currency, everything else equal. Everything else equal, this drop in the monthly current account leads
to a reduction in the countrys reserves and, ultimately, to a depreciation of the Japanese yen. Of course,
this reduction in the current account surplus could also be matched by a reduction in the financial
account deficit, which would have the opposite effect on the yen.
7. The domestic economy seems to be overheating, with rapid economic growth and low unemployment.
News has just been released that the monthly activity level is even higher than expected (as measured
by new orders to factories and unemployment figures). This news leads to renewed fears of inflationary
pressures and likely action by the monetary authorities to raise interest rates to slow the economy
down. Why is this news good or bad for the exchange rate?
Solution
A traditional Fisherian approach, consistent with the parity relations, would suggest that the home
currency should depreciate because of increased inflation. An increase in domestic consumption
could also lead to increased imports and a deficit in the balance of trade. This deficit should lead to a
weakening of the home currency in the short run.
On the other hand, the asset-market approach claims that this scenario is good for the home currency.
Foreign capital investment is attracted by the high returns caused by economic growth and high
interest rates. This capital inflow leads to an appreciation of the home currency.
8. The current Swiss franc/euro rate is 1.5 francs per euro. Inflation rates are approximately 1% in
Switzerland and between 1.8% and 2.2% in the various countries of the euro zone. One-year interest
rates are 2% in Swiss francs and 3% in euros. What would be a natural forecast for the Swiss franc/euro
exchange rate next year?
22 Solnik/McLeavey Global Investments, Sixth Edition
Solution
A natural forecast for the Swiss franc/euro exchange rate next year is the exchange rate prediction
implicit in market quotations, in other words, the forward exchange rate given by:
1.02
1.5 1.48544
1.03
F = = SFr/.
9. Foreign companies are complaining that they are prevented from exporting to Japan by all kinds of
official or unwritten impediments. Try to list some of these impediments. What are the implications
in terms of using PPP to forecast the yen exchange rate?
Solution
Some impediments:
- Import quota (e.g., on rice).
- Numerous regulations preventing foreign service firms from accessing the Japanese market.
- Red tape on imports, introducing long delays and uncertainties about the final delivery costs.
- Poor quality image of foreign goods.
- In public contracts, goods submitted must be of a very particular specification that corresponds
exactly to some existing Japanese goods, but would require costly adjustments for existing
foreign-produced goods.
These barriers to entry lead to violations of the Law of One Price. The same good is more expensive
in Japan than abroad. In turn, PPP is violated and the real yen appears overvalued and can remain so
until these impediments are removed.
10. You believe that the U.S. dollar will strongly appreciate against the euro in the next few weeks. What
action can you take?
Solution
If you believe that the U.S. dollar will appreciate against the euro over its current forward exchange
rate, you can take the following action:
- Today: Borrow euros.
Sell my euros and buy U.S. dollars at the current spot rate.
Lend those U.S. dollars.
- In a few weeks: Sell those U.S. dollars and buy euros at the new spot rate.
If your assumption turns out to be correct, I will make a profit, unless the interest rate differential
already reflects the expectation that the dollar will strongly appreciate.
An equivalent action to be taken today is to enter a forward exchange contract to sell euros and buy
U.S. dollars at the current forward exchange rate, with delivery taking place in a few weeks. At
maturity, you will make a profit if the spot /$ has strongly risen.
Other derivative contracts, such as currency options or swaps, can also be used (see Chapters 10 and 11).
Chapter 3 Foreign Exchange Determination and Forecasting 23
11. An asset manager has conducted an extensive econometric study and proposes a forecasting model.
He has found that a currency with a high interest rate tends to appreciate relative to a currency with
a low interest rate. The simple forecasting model for the one-year exchange rate is that a currency
should appreciate over the year by the amount of the interest rate differential quoted today. For
example, if the Australian dollar exchange rate is AUD/$ = 2 and the one-year interest rates in AUD
and $ are 4% and 7%, respectively, the U.S dollar should move up by 3% relative to the Australian
dollar, and your forecast for the exchange rate at the end of the year is AUD/$ = 2.06.
a. What is the current forward exchange rate?
b. What type of forward transaction would you conduct to capitalize on your forecast?
c. If everyone were using your model and following your strategy, what would happen to the
exchange and interest rates?
Solution
a. According to the interest rate parity relation, F, the current forward exchange rate, is given by:
1.04
2 1.9439
1.07
F = = AUD/$.
b. To capitalize on my forecast for the exchange rate at the end of the year (AUD/$ = 2.06), I can
buy forward dollar contracts for delivery in one year (AUD/$ = 1.9439).
c. If every market participant was using my model, everyone would simultaneously conduct my
type of forward transaction. Hence, the current forward exchange rate would instantaneously
become equal to 2.06. The spot exchange rate and the interest rates would have to move to be
consistent with this forward exchange rate value.
12. Paf is a country with a fixed exchange rate with the U.S. dollar, set at 0.9 pifs per dollar. The Paf
government intends to defend this central parity but has no exchange controls; it can only use an
interest rate policy to defend its national currency, the pif. The pif comes under severe speculative
devaluation pressures because of a drop in the official reserves of Paf. The current (annualized)
one-month interest rates are 18% for the pif and 6% for the dollar.
a. What type of borrowing/lending action could you take to try to take advantage of a devaluation
of the pif ?
b. How much would you stand to lose if Paf is successful in defending its currency?
c. How much would you stand to gain if the pif is devalued to 1 pif per dollar within the next month?
Solution
a. Assume that you speculate on $1,000. To take advantage of an eventual pif devaluation, you
could:
- Borrow 900 pif for one month at
18
%,
12

- buy $1,000,
- lend $1,000 for one month at
6
%.
12

b. Lets assume that Paf is successful in defending its currency. Its means that one month later the
exchange rate will still be set at 0.9 pif per dollar. Then, you will get $
6
12
(1 %) 1,000 + from
your loan in dollars, which will be equal to
6
12
(1 %) 1,000 0.9 + pif. And simultaneously you
will have to pay
18
12
(1 %) 900 + pif.
24 Solnik/McLeavey Global Investments, Sixth Edition
Therefore, your total loss will be equal to:
18 6
Loss 900 1 % 1 % 9 pif
12 12
( | | | |
= + + =
| | (
\ . \ .

or 1% of the capital speculated.
c. Lets assume that the pif is devaluated to 1 pif per dollar within the next month. One month
later, you will get $
6
12
(1 %) 1,000 + from your loan in dollars, which in that case is equal to
6
12
(1 %) 100 + pif, and you will have to pay
18
12
(1 %) 900 + pif.
Hence, your total gain will be equal to:
6 18
Gain 1 % 1,000 1 % 900 91.5 pif.
12 12
( ( | | | |
= + + =
| | ( (
\ . \ .

13. Project using the Web site database:
One would expect that PPP would be better verified for countries with high inflation. Look at the
validity of PPP for Latin American countries relative to the United States.
- Take the end-of-quarter consumer price index data for a sample of high-inflation emerging countries
and the United States for a period of ten years or more. For each country, divide its price index by
that of the United States to obtain its relative price index.
- Take end-of-quarter exchange rates against the U.S. dollar.
- For each country, perform various statistical tests to compare the two series. For example, you can
first plot them, using a common base. You can also calculate their quarterly percent variation and
compare the means of the two series (average inflation differential and average depreciation of the
currency). You could do a regression of the quarterly exchange rate variations on the quarterly
inflation differential and look at the regression coefficients, as well as at the R-square.
- Do a similar calculation for some developed countries (e.g., Japan, Germany, and the United
Kingdom) relative to the United States. Are the conclusions similar?
14. Project using the Web site database:
Take a time series of monthly exchange rates of a major currency relative to the U.S. dollar. Try to
derive a technical analysis that would yield a profitable trading strategy over the period studied. For
example, you could simulate various moving average strategies discussed in the text or simulate
various filter strategies. Apply the strategy that seems most profitable for the previous exchange rate
to other currencies. Perform the same exercise for nondollar exchange rates (for example, for the
CHF/ rate). What do you conclude?