Textbook Problem

Forward versus Spot Rate Forecasts Assume that interest rate parity exists and it will continue to exist in the future. Kentucky Co. wants to forecast the value of the Japanese yen in one month. The Japanese interest rate is lower than the U.S. interest rate. Kentucky Co. will use either the spot rate or the one-month forward rate to forecast the future spot rate of the yen at the end of one month. Your opinion is that net capital flows between countries tend to move toward whichever country has the higher nominal interest rate and that these capital flows are the primary factor that affects the value of the currency. Will using the forward rate for forecasting result in a smaller, larger, or the same absolute forecast error as using today’s spot rate for forecasting the future spot rate of the yen in one month? Briefly explain.