1. Foreign Exchange Rates How to Predict? Samuel, Omar, and Zach

2. Agenda Review Case Review FEX Rate Models Review Models Output Compare Models MSE Select Best Model Predict FEX 2002

3. Case Mr. Ritz’s Models –PPP –MAP –FER –Adhoc UK, Germany, Japan, Mexico, Korea Compare Models (sign, T-Stat, R 2, MSE) Select Model Project Spot FEX rate 2002

4. Models 1.PPP = Purchase Power Parity Model FEX = f(Inflation) = f(I) 2.MAP = Monetary Asset Approach FEX = f(Income Growth, MS Growth) FEX = f(y,m) 3.Forward Exchange Rate Model FEX = f(Interest Rate) = f(i) 4.Ad-Hoc Model FEX = f(Inflation, Income Growth, Current Account) FEX = f(I, y, CA) 5.Martingale-Random Walk FEX = f(Spot Rate Today) = f(St)

5. PPP Model Spot Rate Percentage Change (st),1978-1996 st = a + B1(Id-If) + e CurrencyaB 1R2 USD/BP (T-Stat) 0.003999 (0.5568) -0.37087 (-0.4976) 0.00338 USD/DEM (T-Stat) 0.007282 (0.8118) 0.32774 (0.3452) 0.00163 USD/MEX (T-Stat) 0.010119 (0.4485) 1.11159 (0.2395) 0.22785 USD/Yen (T-Stat) -0.19707 (-1.9617) -1.92352 (-1.8959) 0.04693 USD/WON (T-Stat) 0.000822 (0.2277) 1.06062 (4.1893) 0.19381

6. MAP Model Spot Rate Percentage Change (st), 1978-1996 st = a + B1(yf-yd) + B2(md-mf) +e CurrencyaB 1B 2R2 USD/BP (T-Stat) 0.00488 (0.6478) -0.37693 (-0.4993) -0.04453 (-0.4632) 0.00586 USD/DEM (T-Stat) 0.00826 (0.9263) 0.41886 (0.4438) -0.24478 (-1.4869) 0.03137 USD/MEX (T-Stat) 0.00572 (0.2488) 1.02313 (4.0013) 0.13837 (0.9888) 0.23820 USD/Yen (T-Stat) -0.01671 (-1.657) -1.53893 (-1.4961) 0.25139 (1.6663) 0.08232 USD/WON (T-Stat) -0.00160 (-0.431) 1.21573 (4.7123) 0.08196 (2.1156) 0.28868

7. FER Model FT = Spot Rate * (1+US Interest Rate*T/360) (1+Foreign Interest Rate* T/360)

8. Ad-Hoc Model Spot Rate Percentage Change (st), 1978-1996 st = a + B1(Id-If) + B2(yf-yd) + B3(USCAg) +e CurrencyaB 1B 2B 3R2 USD/BP (T-Stat) 0.03704 (3.0662) 0.60842 (2.5267) 0.36509 (0.7371) 0.00091 (2.143) 0.1479 USD/DEM (T-Stat) 0.00997 (1.1735) -0.36690 (-1.3406) 0.189127 (0.5274) -0.00041 (-1.017) 0.03685 USD/MEX (T-Stat) 0.00569 (0.2122) - 0.23995 (-3.896) -0.15503 (-0.6551) 0.00010 (0.1186) 0.17950 USD/Yen (T-Stat) -0.03256 (-3.448) 1.09910 (3.833) -0.2689 (-0.4867) -0.00021 (-0.584) 0.18356 USD/WON (T-Stat) -0.00517 (-0.746) -0.20583 (-2.1835) 0.04512 (2.5798) 0.00001 (0.0910) 0.12798

9. Martingale-Random Walk Model FT = St MSE = (ST-St)^2

10. Compare Models Out of Sample 1997-1999 MSE = 1/n * S(St est. – St act ) 2 Model USD/BPUSD/DEMUSD/MEXUSD/YenUSD/WON PPP 0.000270.0396140.0000260.000000350.00000001947 MAP 0.000240.0409990.0000310.000000340.00000001937 FER 0.000030.0000320.0000220.000000010.00000000019 Ad-hoc 0.000560.0391740.0000940.000000430.00000002144 RW 0.002260.0383250.0000230.000000320.00000001931

11. USD/BP

12. Forward Projection Based on the FER Model 2000-2002