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.

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Answer 1

The MNC are looking at future cash flows for budgeting, hence forward rates would be more appropriate for usage. This is also true since MNC are generally not in the business of profiting from fx movement (though they may have treasury operations) and hence most likely they will hedge their exposure either fully or partially and the forward rates are good proxy for the hedging cost also plus it obviates the need for doing any specific future spot rate analysis. The expectations about an economy's future period health and inflation/interest rates are all captured in a single number the forward rate, hence the MNC should use the same