IRP, Expectations, and Forecast Error Assume that interest rate parity exists, and that it will continue to exist in the future. Assume that interest rates of the United States and the United Kingdom vary substantially in many periods. You expect that interest rates at the beginning of each month will have a major effect on the British pound’s exchange rate at the end of each month because you believe that capital flows between the United States and the United Kingdom influence the pound’s exchange rate. You expect that money will flow to whichever country has the higher nominal interest rate. At the beginning of each month, you will use either the spot rate or the one-month forward rate to forecast the future spot rate of the pound that will exist at the end of the month. Will the use of the spot rate as a forecast result in smaller, larger, or the same mean absolute forecast error as the forward rate when forecasting the future spot rate of the pound on a monthly basis? Explain.

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 9, Problem 28QA
Textbook Problem

IRP, Expectations, and Forecast Error Assume that interest rate parity exists, and that it will continue to exist in the future. Assume that interest rates of the United States and the United Kingdom vary substantially in many periods. You expect that interest rates at the beginning of each month will have a major effect on the British pound’s exchange rate at the end of each month because you believe that capital flows between the United States and the United Kingdom influence the pound’s exchange rate. You expect that money will flow to whichever country has the higher nominal interest rate. At the beginning of each month, you will use either the spot rate or the one-month forward rate to forecast the future spot rate of the pound that will exist at the end of the month. Will the use of the spot rate as a forecast result in smaller, larger, or the same mean absolute forecast error as the forward rate when forecasting the future spot rate of the pound on a monthly basis? Explain.

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