FINA 7386 – CASE 1 Ntianu Okam Ntianu Okam Chiedu Osuno Chiedu Osuno Ben Tuan Ben Tuan

FORECAST MODELS  PPP  FORWARD EXCHANGE RATES  MONETARY APPROACH  AD-HOC ECONOMIC MODELS

CURRENCIES  USD  GBP  DEM  JPY  PESO  KOW

MODEL ANALYSIS  PPP PROCESS – Based on law of one price –Issues  Ignores financial transactions  Absence of costs  Assumes prices and exchange rates flexible

Relative PPP  Weaker version of Absolute PPP  Takes costs into account  Used to calculate the cost of Currency –Depreciates to PPP = overvalued –Appreciates to PPP = undervalued

Why use PPP  Stable Long Run Predictions  PPP Exchange rates are better predictors of economic fundamentals across countries

 FORWARD EXCHANGE RATES Otherwise known as expectation hypothesis. Is not a regression model.

 MONETARY APPROACH States that Fx rates are asset prices traded in efficient markets States that Fx rates are asset prices traded in efficient markets

 AD-HOC MODEL –A fundamental approach to forecasting exchange rates. –Based on fundamental economic variables –Further modified through statistical means –It is a mixture of art and science

RESULTS COMPARED - GBP Mean Avg. Error – out of sample T-stat R2R2R2R2 PPP Not a regression model Forward exchange Not a regression model Monetary asset Refer to worksheet 5% 5% Ad-Hoc model Refer to worksheet 5%

RESULTS COMPARED - JPY Mean Avg. Error – out of sample T-stat R2R2R2R2 PPP Not a regression model Forward exchange Not a regression model Monetary asset Refer to worksheet 1% 1% Ad-Hoc model Refer to worksheet 4% 4%

MODEL OF CHOICE  Based on estimated RSQ, t-stat, and MAE, the Ad-hoc model will be the most effective to use.  Ad-Hoc spot rate forecast for : GBP USD/GBP JPY USD/JPY