If Smith's statement on parity conditions is correct, future spot exchange rates are most likely to be forecast by:

A. current spot rates.

B. forward exchange rates.

C. inflation rate differentials.

Transcribed Image Text:

Ed Smith is a new trainee in the foreign exchange (FX) services department of a major global bank. Smith's focus is to assist the senior FX trader, Feliz Mehmet, CFA. Mehmet mentions that an Indian corporate client exporting to the United Kingdom wants to estimate the potential hedging cost for a sale closing in one year. Smith is to determine the premium or discount for an annual (360-day) forward contract using the exchange rate data presented in Exhibit A: Exhibit A: Select Currency Data for GBP and INR Spot (INR/GBP) Annual (360-day) LIBOR (GBP) Annual (360-day) LIBOR (INR) 79.5093 5.43% 7.52% Mehmet is also looking at two possible trades to determine their profit potential. The first trade involves a possible triangular arbitrage trade using the Swiss, U.S., and Brazilian currencies, to be executed based on a dealer's bid/offer rate quote of 0.5161/0.5163 in CHF/ BRL and the interbank spot rate quotes presented in Exhibit B: Exhibit B: Interbank Market Quotes Currency Pair CHF/USD BRL/USD Bid/Offer 0.9099/0.9101 1.7790/1.7792 Mehmet is also considering a carry trade involving the USD and the euro. He anticipates it will generate a higher return than buying a one-year domestic note at the current market quote due to low U.S. interest rates and his predictions of exchange rates in one year. To help Mehmet assess the carry trade, Mehmet provides Smith with selected current market data and his one-year forecasts in Exhibit C: Exhibit C: Spot Rates and Interest Rates for Proposed Carry Trade Currency Pair Projected Spot Rate Today's One-Year LIBOR (Price/Base) Spot Rate Today in One Year USD 0.80% CAD/USD 1.0055 1.0006 CAD 1.71% EUR/CAD 0.7218 0.7279 EUR 2.20% Finally, Mehmet asks Smith to assist with a trade involving a U.S. multinational customer operating in Europe and Japan. The customer is a very cost-conscious industrial company with an AA credit rating and strives to execute its currency trades at the most favorable bid/offer spread. Because its Japanese subsidiary is about to close on a major European acquisition in three business days, the client wants to lock in a trade involving the Japanese yen and the euro as early as possible the next morning, preferably by 8:05 a.m. New York time. At lunch, Smith and other FX trainees discuss how best to analyze currency market volatility from ongoing financial crises. The group agrees that a theoretical explanation of exchange rate movements, such as the framework of the international parity conditions, should be applicable across all trading environments. They note such analysis should enable traders to anticipate future spot exchange rates. But they disagree on which parity condition best predicts exchange rates, voicing several different assessments. Smith concludes the discussion on parity conditions by stating to the trainees: "I believe that in the current environment both covered and uncovered interest rate parity conditions are in effect." The conversation next shifts to exchange rate assessment tools, specifically the techniques of the IMF Consultative Group on Exchange Rate Issues (CGER). CGER uses a three-part approach that includes the macroeconomic balance approach, the external sustainability approach, and a reduced- form econometric model. Smith asks Leslie Jones, another trainee, to describe the three approaches. In response, Jones makes the following statements to the other trainees and Smith: Statement 1: "The macroeconomic balance approach focuses on the stocks of out- standing assets and liabilities." Statement 2: "The reduced-form econometric model has a weakness in underestimating future appreciation of undervalued currencies." Statement 3: "The external sustainability approach centers on adjustments leading to long-term equilibrium in the capital account."