Chapter 22 - Forecasting Foreign Currency Exchange Rates

Question 1

What are factors that effect exchange rate ?

Answer 1

1. Rate of inflation in the two countries
2. Level of interest in two countries
3. Economic prospects
4. The balance of payments

Question 2

What is purchasing power parity ?

Answer 2

In reality it’s impossible to predict future exchange rates because of the factors involved however for this exam we use purchasing power parity

This theory uses inflation rates to predict the future movements in exchange rates

Question 3

An example of purchasing power parity

Answer 3

What will the exchange rate be in 1 years time with below info ?

Current exchange rate is $/£ 1.70
US exchange rate is 5% and UK is 2%

$/£1.70 means quoted against the pound so therefore £1 = $1.70

The purchasing power parity looks at the change in interest rates to forecast what the future rate will be so imagine 100 today will be $105 and £102 next year therefore 1.05/1.02 x $1.70 = $1.75

Note if we need to find out the exchange rate in 2 years it’s (1.05/1.02) power of 2 x $1.70 = $1.80