5. Forecasting future exchange rates Business managers often need to forecast fu

Question

5. 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 Lucky 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 t 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 0.000870 dollars per won O 0.005551 dollars per won O 0.000725 dollars per won O 0.000756 dollars per won Thus, the value of the U.S. dollar will against the won in five years.

Explanation / Answer

1) From the information gathered by the finance department's forecasting team of Lucky Corp., inflation rate in South Korea is going to be 10% on an average for next 5 years vis-a-vis 5% in USA for next 5 years. It means that people will have to pay more for less. This would require South Korean government to inject more liquidity into the economy in order to combat inflation and thereby sustain the purchasing power of South Korean populace. As a result,. South Korean won would depreciate in value. Thus, the difference observed in respective yields is due to inflation rate differentials which has a cascading effect on the value of South Korean won.

2) Based on the team's forecast of 5 years future spot rate for South Korean won Vs US dollar and comparison with the current exchange rate, the value of US dollar will effectively appreciate against Won in 5 years.

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