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Chapter 21

Q. 21.FSE.1

New Hampshire Co. expects that monthly capital flows between the United States and Japan will be the major factor that affects the monthly exchange rate movements of the Japanese yen in the future, as money will fl ow to whichever country has the higher nominal interest rate. At the beginning of each month, New Hampshire Co. will use either the spot rate or the forward rate to forecast the future spot rate that will exist at the end of the month. Will the spot rate result in smaller, larger, or the same mean absolute forecast error as the forward rate when forecasting the future spot rate of the yen on a monthly basis? Explain.

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Verified Solution

The accuracy from forecasting with the spot rate will be better. The forward rate is higher than the spot rate (it has a premium) when the interest rate is lower. So if the forward rate is used as a forecast, it would suggest that a currency with the lower interest rate will appreciate (in accordance with the international Fisher effect). Yet, since money is assumed to fl ow where interest rates are higher, this implies that the spot rate will rise when a currency has a relatively high interest rate. This relationship is in contrast to the IFE. Thus, a forward rate will suggest depreciation of the currencies that should appreciate (and vice versa) based on the info in the question. The spot rate as a forecast refl ects a forecast of no change in the exchange rate. The forecast of no change in a currency value (when the spot rate is used as the forecast) is better than a forecast of depreciation for a currency that appreciates. The spot rate forecast results in a smaller mean absolute forecast error.