# Forecasting Foreign Currency Exchange rates

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1. says

Dear Sir, I am doing the specimen questions and I am confused as to why the purchasing power parity could not have been used to forecast the 6 month forward exchange rate. The question : The home currency of ACB Co., is the dollar and it trades with a foreign Co. whose currency is the Dinar. ……….. Home Foreign country…………………..Interest…………………3%………………7%………………………………….
……………………………..Inflation…………………2%………………5%……………………………………………….The answer given is …20.39 (interest rate parity) which I understand, but why wasn’t the Purchasing Power Parity used?

• says

Forward rates are never determined by purchasing power parity.
They are determined by interest rates (and in real life give the same result as money market hedging because the bank is using the interest rates to determine the forward rate).

Forward rates are not predictions/guesses/ forecasts.

Only if we are forecasting what will happen to the spot rate in the future might we use PPP.

• says

Thank you…got it….forward rate using the spot rate and interest rates of both countries and future spot rate using spot rate and inflation rates of both countries!! Thank you!!

2. says

Dear John,
i am afraid, u didnt talk about the fisher effect topic, do we need the formula or not necessary?

• says

The Fisher Effect is not directly related to exchange rates.

It relates interest rates to inflation rates and its relevance in the exam (occasionally) is when dealing with inflation in NPV calculations. It is dealt with in those lectures.

• says

Lectures are not downloadable – it is the only way that we can keep this website free of charge.

3. says

I might have missed it on the video, but did you say you were going to explain why the interest rate parity formula starts with F0, as opposed to F1, like with the purchasing power formula? My curiosity is getting the better of me!

• says

It is more of a Paper P4 thing (both papers use the same formula sheet), but the reason is that when the banks quote forward rates (covered in the chapter/lectures on foreign exchange risk) they do not just ‘guess’ a rate but they calculate it based on the interest rates.

So….Fo is the forward rate that they quote now.

(If forward rates do not mean much to you then read my answer again when you have covered foreign exchange risk management )

• says

Thanks for explaining that for me. I’m working through your lectures bit by bit, so I’m sure when I’ve covered foreign exchange risk I’ll understand your answer more fully!

4. says

I don’t understand, if the model is so unreliable, because it does not take a lot of factors into consideration, why are we supposed to learn it?

• says

@annchen, It is impossible to forecast future exchange rates, whatever factors you try and take into account.

Inflation and interest rates are two factors that can be measured and at least give an indication. How would you go about trying to measure other factors?
Anyway there is not exactly very much to learn since the formulae are given on the formula sheet

• says

@johnmoffat,
monte carlo simmulation? anyway nothing approachable at f9
will attempt p4 due to your lectures, i really enjoyed them!

• says

@annchen, Thank you
With regard to simulation, the most he is ever likely to ask at F9 is what he asked in question 1 of June 2010.

5. says

Awesome… Just Loved it, using these lectures to revise some F9 Stuff for P4 Prep.

6. says

great stuff.By the way, the question he has discussed is actually on page number 180.