Question

Which Exchange Rate Forecast Technique Should MNCs Use?

POINT: Use the spot rate to forecast.  When a U.S.-based MNC firm conducts financial budgeting, it must estimate the values of its foreign currency cash flows that will be received by the parent.  Since it is well documented that firms can not accurately forecast future values, MNCs should use the spot rate for budgeting. Changes in economic conditions are difficult to predict, and the spot rate reflects the best guess of the future spot rate if there are no changes in economic conditions.

COUNTER-POINT: Use the forward rate to forecast. The spot rates of some currencies do not represent accurate or even unbiased estimates of the future spot rates. Many currencies of developing countries have generally declined over time. These currencies tend to be in countries that have high inflation rates. If the spot rate had been used for budgeting, the dollar cash flows resulting from cash inflows in these currencies would have been highly overestimated. The expected inflation in a country can be accounted for by using the nominal interest rate. A high nominal interest rate implies a high level of expected inflation. Based on interest rate parity, these currencies will have pronounced discounts. Thus, the forward rate captures the expected inflation differential between countries because it is influenced by the nominal interest rate differential. Since it captures the inflation differential, it should provide a more accurate forecast of currencies, especially those currencies in high-inflation countries.

WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

Answer 1

The MNC Should Use Market Based Forecasting technique as  it uses market indicators to develop forecasts. the current and forward rates are often used as speculators want to ensure that current rate reflect the market expectation of future exchange rate .

Its better for MNCs to use forward rate to forecast as economic conditions are changing and currencies of developing countries are declining. Interest rate parity will cover inflation difference . In my view also forward rate forecasting technique is better as it covers all the aspects and in spot rate forecasting no such adjustments are considered for change time value of cash flow. forward rate forecasting has various theories for adjusting inflation difference.