Question

Challenges in exchange rate forecasting

Answer 1

Challenges in forecasting of exchange rate:

Following are some of the challenges:

• Purchasing power parity, interest rate parity & international fisher effects can only show 10% of the changes or variations in the exchange rates.
• There is problem with underestimated situations & its influence on exchange rate variations.
• Small movements in exchange rate fluctuations can be predicted easily but large movements can’t be predicted with level of certainty.

Apart from this following are some of the exchange rate risks that make forecasting difficult:

• Transaction risk – this is a cash flow risk that deals with the effect of exchange rate moves – it influences to receivables, payables or repatriation of dividend.
• Translation risk – this is a balance sheet exchange risk – here the exchange rate moves to the valuation of foreign subsidiary’s balance sheet & in turn affects the balance sheet of the parent company.
• Economic risk – this is a risk to the present value of future operating cash flows from exchange rate movements. The economic risk has an influence on exchange rate on revenues i.e. domestic sales & exports & operating expenses i.e. cost of domestic inputs & imports.