Question

Predicting Exchange Rate Movements

Whether international businesses are concerned with the long-term profitability of foreign investment, export opportunities, the price competitiveness of foreign imports, or the short-term foreign exchange transactions that occur on a daily basis, the firm must pay attention to exchange rate movements. These movements can affect whether a deal results in a profit or a loss.

Exchange rate movements are extremely difficult to predict, though businesses need some forecasting ability to plan. A number of theories, methods, and borrowings from other disciplines have been applied to the movement of exchange rates. Some approaches work better in the short-run, while others apply more appropriately to longer-term plans. Managers in international enterprises must understand the predictive power and uses of the theories and approaches to use them effectively in strategy and operations.

Select whether each factor is a better short-range predictor or long-range predictor of movement in foreign exchange rates.

1. A government can increase the supply of money, which makes it easier for individuals and businesses to get credit. This, in turn, can increase the demand for goods and services, which should grow at the same rate to avoid inflation.

2. Market traders tend to follow the actions of other traders but the individual effects can be hard to predict.

3. Evidence reveals that various psychological factors play an important role in determining the expectations of market traders.

4. Nominal interest rate is the sum of the required “real” rate of interest and the expected rate of inflation during the loan period. A strong relationship exists between nominal interest rates and inflation rates.

5. Expectations of market traders tend to become self-fulfilling prophecies.

6. If the growth in a country’s money supply is faster than the growth in its output, price inflation is fueled.

Answer 1

Points 2,3,5 & 6 are the short-range predictors of exchange rate movements because these factors can help predict the change in exchange rate only over a short period of time. An increase in country's money supply will lead to inflation but these only help over a short period of time,so also factors like self-fulfilling prophecies of traders , psychological factors etc because self-fulfilling prophecies or psychological factors are speculations and these speculations are effective only for short period of time. These kind of prophecies may not always yield long-term results.

If any business wants to predict correctly the exchange rate over a longer period of time,then these factors 1,4 are more effective in predicting the changes in exchange rate over a longer period of time.