FNCE 4103 Week 4 Exchange Rate Forecast Critique Example

Testing a Bank's Call for the Euro at $1.15 in Twelve Months Against Interest Parity, Purchasing Power Parity, the Forward Quote and the Record of Currency Forecasts

Student Name

Walden University

FNCE 4103: International Finance

Instructor Name

Month Day, Year

Testing a Bank's Call for the Euro at $1.15 in Twelve Months Against Interest Parity, Purchasing Power Parity, the Forward Quote and the Record of Currency Forecasts

The Forecast

The forecast under review is from a composite bank's foreign exchange research note dated on the same trading day as Lakeland Process Equipment's spot quote of $1.0850 per euro. It reads: "We expect EUR/USD to rise to 1.15 over the next twelve months." The publisher is described as a large international bank's currency strategy team; the note is composite, written for this exercise in the form such notes take. Lakeland's treasurer is considering whether to rely on it in deciding whether to hedge future euro payables.

The Forecast's Reasoning

In the writer's own words, the note argues that the euro will strengthen because the U.S. central bank is expected to cut interest rates faster than the European Central Bank, narrowing the gap that has supported the dollar, and because the euro area's trade surplus continues to bring demand for euros. It forecasts a 6.0 percent rise in the euro over a year, from $1.0850 to $1.15, and gives no range around that figure.

Test 1: What Interest Rate Parity Implies

Using illustrative one-year rates of 4.8 percent in dollars and 3.4 percent in euros, parity puts the one-year forward at 1.0850 x 1.048 / 1.034 = $1.0997. The forward rate is not a forecast in itself, but under the expectations hypothesis it would be an unbiased predictor of the future spot rate. The bank's 1.15 is about 4.6 percent above the parity-implied forward.

Test 2: What Purchasing Power Parity Implies

Relative purchasing power parity holds that exchange rates move to offset inflation differences. With illustrative expected inflation of 3.0 percent in the United States and 2.2 percent in the euro area, the euro would rise by about 0.8 percent, to 1.0850 x 1.030 / 1.022 = $1.0935. Purchasing power parity is a weak guide over a single year, because real exchange rates drift far from it for long periods (Rogoff, 1996), but it gives no support to a 6 percent move.

Test 3: What the Forward Quote Shows

The bank's own one-year forward quote, consistent with the interest rate inputs, is about $1.0995. A treasurer who believed the bank's forecast could act on it by not hedging. Hedging at $1.0995 would lock in a rate about 4.6 percent below the forecast; leaving the exposure open would save that amount only if the forecast proved right.

Test 4: The Record of Currency Forecasts

Meese and Rogoff (1983) found that economic models of exchange rates could not forecast better over one-year horizons than a simple random walk, which predicts that the rate will stay where it is. Later research has softened but not overturned that finding: forecasts based on interest rate and inflation differences have little short-run power (Rossi, 2013). A forecast of a 6 percent move over a year is therefore a strong claim that needs strong evidence.

What Would Make the Forecast More Credible

Three additions would strengthen the note. First, a range rather than a point: a forecast of 1.15 with a stated band, say 1.05 to 1.20, would tell a reader how confident the authors are. Second, a stated probability: a forecaster who says there is a 60 percent chance the euro ends above the forward rate gives a treasurer something to weigh. Third, a track record: the bank could report how its past twelve-month calls compared with outcomes. None of these appears in the note, which presents a single number with a short story behind it. The note may still be useful as a description of how the bank's strategists see the risks, but it is not evidence that the euro will reach 1.15.

Verdict

The forecast's reasoning is plausible: narrowing interest rate differences can strengthen the euro. But its size is well beyond what interest parity, purchasing power parity or the forward market imply, and the track record of such forecasts is weak. The treasurer should not use it to decide whether to hedge. If the forecast is right, an unhedged Lakeland would save money; if it is wrong in the other direction, an unhedged Lakeland would pay more for its euro inputs. Hedging decisions should rest on how much uncertainty the company can bear, not on a single forecast. For Lakeland, whose sales are entirely in dollars and whose margins on each production line are thin, that points toward hedging most of its known euro payables and leaving forecasts to inform, at most, the timing of when it hedges.

References

Meese, R. A., & Rogoff, K. (1983). Empirical exchange rate models of the seventies: Do they fit out of sample? Journal of International Economics, 14(1-2), 3-24. https://doi.org/10.1016/0022-1996(83)90017-X

Rogoff, K. (1996). The purchasing power parity puzzle. Journal of Economic Literature, 34(2), 647-668.

Rossi, B. (2013). Exchange rate predictability. Journal of Economic Literature, 51(4), 1063-1119. https://doi.org/10.1257/jel.51.4.1063