1. (a) The diagram below depicts international parity relationships in equilibrium.

Difference in Difference in actual

national interest A or expected inflation
rates

B C D

Difference E Expected change in

between forward spot rates
and spot rates

Letter A is the Fisher effect. The Fisher Effect is an economic theory created by economist
Irving Fisher that describes the relationship between inflation and both real and nominal
interest rates. The Fisher effect state that the real interest rate equals the nominal interest rate
minus the expected inflation rate, therefore real interest rates fall as inflation increases, unless
nominal rate increase at the same rate as inflation

Letter B is the Interest Rate Parity (IRP).It states that as a result of market forces the forward
rate differs from the spot rate by an amount that sufficiently offsets the interest rate
differentials between two currencies and then covered interest arbitrage is no longer feasible
and the equilibrium state is achieved .When IRP exist the rate of return achieved from
covered interest arbitrage should equal the rate of return available in the home country.

Letter C depicts the International Fisher Effect. It state that the difference between the
nominal interest rate in two counties is directly proportional to the changes in the exchange
rate of their currencies at any given Time. It is based on current and future nominal interest
rates and it is used to predict spot and future currency movement

Letter D, depict the Purchasing Power Parity relationship, it state that spot exchange rates
between currencies will change to the differential in inflation between countries .It can be
Absolute purchasing Power Parity (APPP) or Relative Purchasing Power Parity
(RPPP) .APPP it states that price levels adjusted for exchange rates should be equal between
countries where one unit of currency has same purchasing power globally. While RPPP states
that the exchange rate of one currency against another will adjust to reflect changes in the
price levels of the two countries

Letter E depicts forward rate as an unbiased estimator of the future spot rate .Forward rate as
an unbiased estimator of the future spot rate when the expected future spot rate is equivalent
to the forward rate.

1 (b)

(i) If you trade using these forex quotations, how many EUR, NZD and GBP do you
have at departure? [6]

(a)USD1=EUR1.304
Therefore USD1000 =1000*1.304
=EUR1304

(b) USD1=NZD0.67
Therefore USD1000=1000*0.67
=NZD670

(c)USD1=GBP1.9
Therefore USD1000=1000*1.90
=GBP1900

On point of departure I will be having EUR1304; NZD600 and GBP1900

(ii) If you return with EUR300, NZD1 000 and GBP75 and the prevailing exchange
rates are unchanged, how many USD will you have after trading?

(a)USD1=EUR1.305
1
That is EUR1= USD
1.305

300
Therefore EUR300=
1.305

=USD 229.89

(b) USD1=NZD0.69
1
That is EUR1 =USD
0.69
 100
Therefore NZD100=
0.69

=USD144.93

(c) USD1=GBP1.95

1
That is GBP1 =USD
1.95

75
Therefore GBP75 =
1.95

=USD38.46

On point of return I will be having 229.89+144.93+38.46 =USD413.28

 2. “Foreign exchange forecasting is vital for multinational corporations”. Discuss.
[25]

Economic globalization is an irreversible trend that have taken world economies by force.
There is an increasing interdependence of the world economies where there is the growing
scale of cross-border trade of commodities and services, huge flow of international capital
and wide and rapid spread of technologies and this has led to the emergence of Multinational
corporations .Multinational corporations are corporate organisations that owns or controls
production of goods or services in at least one country other than its home country
(Wikipedia) .These corporates and investors need to know how their investment will change
in their currency and for reporting purposes as it is a norm that they have one reporting
currency that they prepare their financial statement in .In order to facilitate this phenomenon
there is need to have efficient foreign exchange system that act as a linkage between different
currencies in which the multinationals corporates trade in . Foreign exchange rate is the price
of the domestic currency stated in terms of another currency, in simpler terms a foreign
exchange rate compares one currency with another currency. When Multinational corporates
enter into Forex market they should enter cautiously and come prepared and this is when
forecasting of foreign exchange come into play. Forecasting of foreign exchange means
predicting current and future market trends by utilizing existing data and various facts.

Forecasting of foreign exchange rates is mainly done by many analyst and financial
institutions for different currency pairs and they use two different types of exchange rate
forecast that is fundamental forecast and technical forecasts, which are periodically reported
by banks and analysts covering different currencies and financial news agencies such as
Reuters and Bloomberg collect these forecast from the experts to produce periodic
reports .The Multinationals Corporates will then follow these foreign forecasts in order to
make various decisions .Hence forecasting of foreign exchange is very vital to multinational
corporates in various ways which will be discussed in this essay.

Medium term pricing policies –to quote in forex there is need to forecast exchange rates

International investment analysis for example both for portiflio and foreign direct
investment
Purchasing and souring policies

Product competitive assessment

Foreign exposure management

oreign exchange exposure refers to the risk a company undertakes when making financial
transactions in foreign currencies. All currencies can experience periods of high volatility which can
adversely affect profit margins if suitable strategies are not in place to protect cash flow from
sudden currency fluctuations. Exchange rate risk can usually be managed through effective,
preemptive hedging.

When supply chain payments or critical accounts are based in foreign currencies, companies may
choose to employ a targeted currency strategy to minimise foreign exchange exposure. These
strategies usually involve contracts that allow companies to lock in an exchange rate for an extended
period of time, often up to one to two years.

W Motives for Forecasting.

Explain corporate motives for forecasting exchange rates.
ANSWER: Several decisions of MNCs require an
assessment of the future. Future exchange rates
will affect all critical characteristics of the firm
such as costs and revenues. To be more specific,
various operations of MNCs use exchange ra
te projections, including hedging, short-term
financing and investing, capital budgeting deci
sions, long-term financing, and earnings
assessment. Such operations will be more effective
if exchange rates are forecasted accurately.

orking capital managemt i.e the most effiecient timing of cash flow movement

https://admiralmarkets.com/education/articles/forex-strategy/forex-forecasts-basic-forex-
forecasting-techniques

Contemporary Financial Management

By R. Charles Moyer, James R. McGuigan, Ramesh P. Rao
https://www.investopedia.com/terms/r/relativeppp.asp
https://en.wikipedia.org/wiki/Relative_purchasing_power_parity
https://www.kantox.com/en/glossary/exchange-rate-forecast/