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On February 7, 2011, the value of the dollar in terms of the Japanese yen was ¥82.38/$. On December 28, 2015, less than five years later, the exchange rate was ¥120.25/$; the dollar appreciated by almost 46% relative to the yen. What drives such extraordinary changes in relative currency valuations, and can we predict their direction and magnitude? On the one hand, the answer to the forecasting question must be yes because financial institutions devote substantial resources to producing forecasts for their clients, and forecasting firms successfully market currency forecasts. Yet, the answer may be no because economic models often fail to explain exchange rate movements after the fact.
Corporations use currency forecasts in a variety of contexts: quantifying foreign exchange risk, setting prices for their products in foreign markets, valuing foreign projects, developing international operational strategies, and managing working capital. International portfolio managers use exchange rate forecasts to evaluate the desirability of investing in particular foreign equity and bond markets and whether to hedge the associated currency risks.
Should managers purchase currency forecasts? If markets are relatively efficient, it should be difficult to produce better short-term forecasts than forward exchange rates portend or better long-term forecasts than uncovered interest rate parity predicts. Yet, we saw evidence in Chapter 7 that these parity conditions do not always hold, especially in the short run. Therefore, currency forecasts are potentially valuable. This motivates our discussion of the two essential techniques that are used to forecast exchange rates: fundamental analysis and technical analysis. Because of the dramatic currency crises in a number of developing countries with pegged systems in the 1990s, forecasts in these systems are of special interest, and we discuss them separately.
Parity Conditions and Exchange Rate Forecasts
The covered interest rate parity (CIRP) relationship, discussed in Chapter 6, links forward rates, spot rates, and interest rate differentials. Uncovered interest rate parity (UIRP), discussed in Chapter 7, which is sometimes referred to as the international Fisher relation (named for the eminent American economist Irving Fisher), links expected exchange rate changes and interest rate differentials, whereas the unbiasedness hypothesis links forward rates and expected future exchange rates.
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