Question

1.) Fundamental Forecasting Explain the fundamental technique for forecasting exchange rates. What are some limitations of using a fundamental technique to forecast exchange rates?

2.) Market-Based Forecasting Explain the market-based technique for forecasting exchange rates. What is the rationale for using market-based forecasts? If the euro appreciates substantially against the dollar during a specific period, would market-based forecasts have overestimated or underestimated the realized values over this period? Explain.

Answer 1

1. Fundamental forecasting Exchange rate is based on underlying relationships that exist between one or more variables and a currency’s value.

Any change in one or more of these variables will lead to a change in the forecast of the currency’s value.

Limitations-

• If a fundamental relationship exists, it is difficult to accurately quantify that relationship in a form applicable to forecasting.
• If the relationship could be quantified, there is no guarantee that the historical relationship will persist in the future.
• It is difficult to determine the lagged impact of some variables.
• It is also difficult to incorporate some qualitative factors into the model

2)

Market-based forecasts should reflect an expectation of the market on future rates. If the market’s expectation differed from existing rates,then the market participants should react by taking positions in various currencies until the current rates do reflect an expectation of the future.

The market determines the spot exchange rate and forward exchange rate. These market-based rates can be used to forecast since if they were not good indicators of the future rates, speculators would take positions. This speculative movement would force the rates to gravitate toward the expectation of the future spot rate.

Market-based forecasts would have underestimated the realized values of the euro over this period because the actual values were above the spot rates and forward rates quoted earlier.