Inflation / Risk

Increase / Decrease

Forecasting future exchange rates Business managers often need to forecast future exchange rates to hedge their risks. One method for forecasting future exchange rates is to use observed interest rate differentials. Global Satellite Corp., a U.S.-based company, conducts hundreds of business transactions in South Korea. For planning purposes, the company needs to know the estimates of the five-year spot rate for the won per dollar. The company needs to find these estimates, so the finance department's forecasting team has gathered the following information: Inflation in South Korea is expected to be 10.0% on average for the next five years, and inflation in the United States is expected to be 5.0% on average for the same period. The yield on five-year South Korean government bonds is 17.5% per year, whereas the yield on five-year U.S. government bonds is 12.5% per year. The current exchange rate is 0.0009009 dollars per won (USD/KRW). The forecasting team also took into account the differences in the political risk of the two countries. They accounted one percentage point of this yield differential for political risk differences between the United States and South Korea, with the United States perceived as having the lower political risk. Thus, the comparable yield on the five-year South Korean government bonds would actually be 16.5%. If the real rates in the two countries are equalized, the difference observed in the yield is likely to be due to _____. The team's forecast of the five-year future spot rate for the won (versus the U.S. dollar) using the information available is: 0.005551 dollars per won 0.000725 dollars per won 0.000756 dollars per won 0.000870 dollars per won Thus, the value of the won will _____ against the U.S. dollar in five years