Page 192 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes What the theory argues is that an increase in the money supply will lead to a depreciation of the
exchange rate. The extent of the depreciation depends upon the slope of the curves M and B.
For example, if we consider an increase in the domestic money supply, we will anticipate that a
lower interest rate and /or a higher exchange rate can only absorb the excess supply, which in turn
will result in the reduction of bonds. To this end, line M will move to the right and line B will move
to the left.
16.4 Exchange Rate Forecasting

In the previous section we referred to various theories in respect to the main determinant of future
exchange rates. However, it is actually an empirical topic to identify the most important factors. As a
result, we can argue that forecasting exchange rates is a difficult task because of so many factors that
might be regarded as determinants. In addition, using formulas17 (similar to the Interest Rate Parity
Theorem) will result in only imprecise estimates of future currencies exchange, basically because the
data related to inflation differentials and future spot rates are by themselves only estimates.
On the other hand, it remains doubtful weather or not the foreign exchange market is an efficient18
one - since it seems that not all information but only the historical is incorporated in prices (weak
form efficiency).
Although we share the opinion that there is no reliable method available to forecast exchange rates,
we will refer here below to some of the main concepts.
1. The Unbiased Expectations Hypothesis
The concept of the Unbiased Expectations Hypothesis argues that the forward rate is an unbiased
forecaster of the future spot rate. Thus, the forward rate at time t for maturity at time T must
equal the markets expectation at time t for maturity at time T.
FtT = Et(ST)
In addition, the forward price is the expected spot price minus a risk premium to cover likely
interest rate differentials.
FtT = Et(ST) - ?. ? is the risk premium
2. Unbiased or Biased Predictor
Finally, the UEH does not give a quite satisfactory reply as to whether or not a forward rate
may be a biased predictor of a future spot rate.
In this respect, the following equation gives adequate answer to the aforementioned question.
ST = bo + b1 Ft,T + b2 I
St: represents the realized spot rate for the maturity date
FT: represents the forward rate
I: represents any available information that affects the exchange rate
b2: is a statistically significant that represents the market's efficiency if all the information is not
incorporated in the forward rate (inefficient market)
Studying historical data, we can conclude that in the majority of instances the bo does not equal
to zero and the b1 does not equal to 1, which means that the forward rate is actually a biased
predictor of the future spot rate. Contrarily, both the bo and the b1 have a negative value,
demonstrating that there is a risk premium (mentioned earlier) related to the forward rate.
3. Purchasing Power Parity
In accordance with the PPP concept, the inflation differentials between countries affect the
exchange rate, and consequently the PPP could be of good value in order to forecast the exchange
rate. In Cochran & Defina study (Cochran & Defina 1995), they show that the exchange rates,
although they deviate from the PPP, they finally return to their PPP levels. However, during
their deviation the possibility of the exchange rates moving backward from or forwards to the
PPP remains the same, and consequently the PPP did not prove itself to be a consistent or
reliable 'tool' for forecasting.

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