International Financial Management 943
Methods of Forecasting Exchange Rates
There are various methods of forecasting the exchange rates between two or more countries’ currencies (Alvarez-Diaz, 2008). Prediction of exchange rates between countries helps to minimize risks while maximizing the returns. Some of these methods includes purchasing power parity (PPP), relative economic strength approach, econometric models, and time series models, among others.
The forward method uses purchasing power parity (PPP) method where the only consideration is the inflation rates between the two countries (Taylor, 2003). This approach depends on the theoretical law that identical goods will cost the same in different countries excluding the after taking into consideration the exchange rates and excluding the transaction and shipping cost. Based on this, the PPP approach forecasts changes in exchange rates to offset price changes due to inflation only.
A time series model is kind of a mathematical model developed over time and based on various variables as may have been identified practically over time. Some of these variables could be interest rates, business security, assurance for returns, etc. This may be more accurate than just assuming inflation rates only.
The Leader in this particular firm must have had experience that the forward rates estimates was a low estimation of the rates. She must have had developed some mathematical (e.g. time series models) models to estimate the exchange rates from experience. This kind of model may have included data collected over a long period over her working career and hence a better estimation criterion for exchange rates than the one, which merely assumes changes are only due to inflation rates. These ...
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...e higher your risk tolerance, the more you may invest in higher-risk securities offering the potential for greater returns. While there is no foolproof strategy to ensure you are making safe investments, financial advisors are always there to help an investor make informed decisions.
In the current scenario, both investments will have atleast the same returns and hence it will be worthy selecting an investment which has equal or more returns with reduced risk. The speculative investment in the current scenario may be more devastating in terms of returns if, for example, the speculative rates does not happen and instead the forward rates are used at the end of the day. While in this case the investor will still make profit at 2.7%, it will not be as expected at 6.65% while an alternative investment option is available where there is a guaranteed 6.65% or more returns.
Economic indicators are Governmental statistics, released on a regular basis, which indicate the growth and health of a country. Economic indicators often affect and influence the value of a country's currency. The Trade Deficit, the Gross National Product (GNP), Industrial Production, the Unemployment Rate, and Business Inventories are examples of economic indicators. We will be dealing with four specific indicators: interest rate, inflation, unemployment, and employment growth as well as Real Gross Domestic Product (GDP). Real GDP is so called because the affects of inflation and depreciation are accounted for in the figures.
Foreign exchange is a commodity, and its price fluctuates based on supply and demand, like any commodity. This is not the place for a complete discussion of supply and demand as relates to foreign exchange, but for our purposes, we will assume that supply of and demand for a country’s currency moves along with the supply of or demand for that country’s products or the products of its trading partners. For example, if one country buys many more goods from its neighbor than its neighbor buys from it, the balance of payments at the end of the year will cause its neighbor’s currency to be in great demand, thereby driving its price up.
The greatest investors in the world all understand one common theme when it comes to successful investing, “markets are volatile and they fluctuate.” Whether it is real estate investing or investing in stocks, there is an inherent risk. Therefore, new investors who are trying to decide whether to invest their available capital in real estate or stocks must learn to understand their own risk tolerance. To understand risk successfully, new investors must first learn some of the pros and cons of both real estate investing and stock market investing.
Economists have long taken the view that economic fundamentals determine exchange rates. Nevertheless, in the early 1970s, after the collapse of fixed exchange rate regimes of the Bretton Woods system, excess volatility, nonlinear and disorderly movements in exchange rates became mysteries that traditional exchange rate theory cannot explain. Recent scholar concluded “no definitive evidence that economic variable can forecast exchange rate for currencies of nations with similar inflation rates" which is known as “the disconnect puzzle” from Meese and Rogoff’s studies (1983). Thus, this essay aims to explain why is it apparently so difficult to forecast exchange rate movements, and to provide evidence from the relevant literature and the reference of three popular fundamentals-based models, including Monetary Model and Mundell-Fleming Model.
PPP theory is to determine the exchange rate one of the most basic theories, the basic idea is that the exchange rate depends on the price level, rather than the price level depends on the exchange rate. The reasons of people need foreign currency, because it has the purchasing power of general merchandise in the country. Also, the reason is because it has the purchasing power in the country. Therefore, the national currency and foreign currency rating mainly depends on comparing the purchasing power of the two currencies. PPP has two forms: absolute and relative purchasing power parity theory of purchasing power parity theory. Law of one price that the price under the assumption of perfect competition market and domestic goods and foreign goods substitutability between the conditions of existence of completely removing transportation costs, trade barriers and information costs, for a given product, with the same currency price, in different locations will be the same, that the following formula:
Williamson, R. (2001). ‘‘Exchange rate exposure and competition: evidence from the automotive industry,’’ Journal of Financial Economics, Vol. 59, pp. 441-75
The exchange rate simply refers to the value of a currency in terms of another. In essence, the exchange rate of a country’s currency determines the strength of that currency, or its weakness in relation to other currencies. With the increased extent of globalization, currency exchanges have become commonplace in virtually all countries (Zhang). However, the US dollar remains the mostly used form of currency, and usually serves as a standard measure for all the others, which are demanded by the inhabitants of other nations, as well as those who wish to spend the currency forms in the other countries. It is imperative to note that currency can only serve as legal tender as desired when it is in the correct form. It is for this reason that currency
Reduce foreigner exchange rate risk by Hedging using derivatives (Foreign Currency Futures, Foreign Currency Swap, Foreign Currency Options, and Foreign Currency Forward).
According to International Monetary Fund (IMF), PPP is defined as “The rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country”
Economic risk is another type of exchange risks companies have to consider when dealing globally. Changes in exchange rates are bound to affect the relative prices on imports and exports, and that will again affect the competitiveness of a company. An UK exporter dealing with companies in the US would not want the US$ to depreciate, because it would make the exports more expensive for the US market, thus the company will loose business.
One reason is that many successful investment ventures itself is the outcome of these ‘irrationality’. Risk-taking, which is inevitable in investment, may contribute to the investors’ better performance than others, while with the assistance of proper training, assessment accuracy can be increased(Palich and Ray Bagby, 1995). Also, if without precedent, most of the newly-invented value-maximising approaches or strategy of investment ought to be considered as crude and unthoughtful, but in reality, they are regarded as innovation(Busenitz and Barney, 1997). Furthermore, there are evidence shows that instead of being the hindrance of correct investment decision-making, those biases and heuristics are backed up by probabilistic information. Accurate statistical probability can be evaluated by our inductive reasoning mechanism with a relatively high possibility(Cosmides and Tooby,
Exchange rate is a highly crucial factor in determining a country’s growth, provided we are referring to an open-economy. Putting it simply, it acts as an indicator as to how an economy fares with respect to other economies. It determines both, the external position as well as the growth.
Speculating is considered the high-risk trades while investing is considered the lower-risk investments based on fundamental and analysis. Investors who have a higher risk tolerance tend to go for high returns thru speculating. However, investors who cannot tolerance high risk will seek for average or below-average amount of risk with a satisfactory return. However, speculating is not same as gambling as speculators do make a more educated and knowledgeable decision more towards to trade which contain an above average of risk while gamblers do
The foreign exchange market is one of important mechanism in the international business because foreign exchange is an intermediary for all nations in term of the growth of the economy. There are many functions of foreign exchange market in the global economy. In the international business, it uses the foreign exchange markets in four ways. First, the pay...
As the foundation for the foreign exchange process, exchange rates are one of the most important elements in business, both internationally and domestically. Defined as the rate at which one currency may be converted into another, exchange rates are used by countries in order to purchase products or services from one another. When examining these exchange rates it is important to note that their two distinct types of rates used for global trade: nominal and real.