# 2 Finance Questions

Need Q3 and Q4.

1

Foreign Exchange Market and Analysis: Assignment 2

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:

1 1t t tS 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 three-

month 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.

_________________________________________________________________________________

Assignment Guidelines

_______________________________________________________________________________

You will need to provide clear workings to all problems and to provide a focused and succinct answer

to the parts of question 1, whatever your approach and reasoning ability within the word limit. You

should also demonstrate your ability to explain and apply the concepts, theories or models and

assumptions to justify your calculations and or conclusions you may reach. The assignment answers

should be focused and written in an academic and logical manner.

Your assignment must be properly referenced.

References

Bekaert, G. and Hodrick, R. (2018), International Financial Management.

Moosa, I, (2010), International Finance, 3rd Edition, McGraw-Hill.

Pilbeam, K., (2005), International Finance, 3rd Edition, Macmillan.

Copeland, L, (2005), Exchange Rates and International Finance, 3rd Edition, Prentice Hall.