HOMEWORK ASSIGNMENT 2

VIKAS KUMAR SINGH

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Chapter7
Q2:
Describe the joint hypothesis that underlies all tests for market efficiency.
Ans:
The joint hypothesis implies two hypotheses tested at the same time- (1) the
hypothesis that defines market equilibrium prices or market equilibrium returns as
some function of the available information set, and (2) the hypothesis that market
participants have actually set prices or returns to conform to their expected values.

E2:
Examine the daily closing price data on the DM/$ rate in file E07.xls that was used
to construct Figure 7.4. Suppose you were using a 1 percent filter rule to trade the
DM and US$.
a. On what day would the 1 percent filter rule have issued its first signal? Was this a
buy or a sell signal? At what price did the trade occur?
b. On what day would the 1 percent filter rule have issued its second signal? Was
this a buy or a sell signal? At what price did the second trade occur?
c. Calculate the profit from the first trade. Assume that transaction costs are 0.02%
and that the interest rates were constant over the period with iDM = 3.0% and i$ =
5.5%.
Ans:
a. On July 11, 1986, DM/$ rises more than 1 percent that is by 1.29 percent. And
hence as per 1percent filter rule it is a buy signal. And the trade would occur at
2.194 DM/$.
b. On July 14, 1986, DM/$ falls more than 1 percent that is by 1.09 percent. And
hence as per 1percent filter rule it is a sell signal. And the trade would occur at
2.170 DM/$.
c. Profit because of transaction from1st trade= gain on transaction - transaction
cost + Interest earned
=1.29% - (2 *.02) + (5.5% - 3.0%)*(3/365)
= 1.29% - 0.04% + 0.02%
=1.27%

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Chapter 8
Q1:
Explain the difference between an accurate forecast and a useful forecast. Who
needs an accurate forecast?
Ans:
Accurate forecasts have small forecasting errors, which are measured by traditional
statistical measures such as the root mean squared error (RMSE) or the mean
absolute error (MAE).
Useful forecasts are those on the right side of the market and lead to profitable
speculative positions and correct hedging decisions.
A portfolio manager who changes the magnitude of his currency position based on
the expected percentage change in the currency needs accurate forecasts based on
RMSE and MAE.

Q4:
"Short-term exchange rate forecasting requires a strong emphasis on economic
fundamentals." True or False? Explain.
Ans:
The above statement is true in some situations and false in case of some of the
other situations. Such as, if forecasting of the exchange rate is done on the basis of
the news announcements, there is strong emphasis on the economic fundamentals.
But when short term exchange rate forecasting is done using technical models they
do not require a strong emphasis on economic fundamentals.

Q5:
"Purchasing Power Parity measures are a powerful tool for short-term forecasting."
True or False? Explain.
Ans:
The above statement is false. PPP plays a more important role in long-term
forecasting by giving a reasonable approximation of where the next central rate
realignment is headed. But the timing of realignment is uncertain and hence the
short term forecasting. The timing of realignment is guided by economic
considerations and political considerations.

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Q7:
Explain the limitations of the regression method for forecasting future exchange
rates using current and past exchange rates.
Ans:
Regression method assumes that there is a linear or proportionate relationship
between past trends and future forecast i.e. if the exchange rate has gone up in the
past, it is likely to go up in the future. But the underlying relationships may not be
linear.

Q9:
What is composite forecasting? Under which conditions would a composite forecast
outperform individual forecasts?
Composite forecasting is a method for producing forecasts by bringing together the
information from alternative forecasting models of other individual forecasts.
The conditions under which, a composite forecast will outperform an individual are:
(1) The individual forecasts must reflect different information elements.
(2) We must have a technique (such as linear regression) for estimating the
weights for combining individual forecasts.
(3) The relationship between the individual forecasts which determines the
weights must be stable over time.

Q10:
What are the main problems for forecasters using econometric models to forecast
exchange rates?
Ans:
The main problems for forecasters using econometric models to forecast exchange
rates are:
(1) The availability of adequate data
(2) The problem of forecasting the right hand side variables
(3) The econometric models assumes certain degree of stability or stationarity in
the system

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E1:
Assume that your company exports to Japan and earns yen revenues, thus forecasts
of the Yen/$ rate are important. Suppose two forecasters issue their predictions for
the Yen/$ exchange rate. The current spot rate is Yen 90/$. Forecaster A predicts a
rate of 98 next month and forecaster B predicts a rate of 88. The forward rate is at
89, reflecting the interest rate differential between the two currencies. One month
later, the spot rate reaches 92 Yen/$.
a. Which of the forecasters, A or B or the forward rate made the most accurate
forecast?
b. Which one is the most useful?
Ans:
a.
The future spot rate= 92 yen/$
Forecast A= 98 yen/$
forecast B= 88yen/ $
Current spot
rate=90yen/$
Forward rate= 89 yen/$
Error in A= (98-92)/92=6/92= 6.52%
Error in B= (92-88)/92=4/92= 4.35%
Error in forward rate= (92-89)/92= 3/92=3.26%
This shows that forward rate is the most accurate forecast of the all the three,
because it has the least error in its forecast or it is closest to the future spot rate.
b. Since in actual forward spot rate yen has fallen against dollar, this shows that the
forecast of a is most useful as the company would go for hedging as the forward
rate of 89 yen/$ and hence in turn would save money because of falling yen against
dollar where as with forecast B company would not go for hedging and hence inturn
would incur losses by falling yen.

E2:
You are the treasurer of a large multinational company. Suppose that you receive
every month exchange rate forecasts for the Yen/$ exchange rate from five different

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forecasting institutions: A, B, C, D, and E. From your past experience, the best

forecaster has been firm C, followed by A, D, B, and E.
The historic RMSE (standard deviation of forecasting errors) for the five forecasters
and the current predictions are shown in the following table:
Forecas
ter
A
B
C
D
E

RMSE
7
15
5
10
20

Yen
Forecast
80
82
85
81
88

a. Calculate the composite forecast that results from evenly weighting these five
forecasts.
b. Calculate a composite forecast as described in the chapter that assigns greater
weight to forecasts with greater accuracy.
c. Discuss the advantages and disadvantages of using the forecast in (b) versus (a).
Ans:
a.
Evenly weighting will give as weightage of 20% for each of the forecasts
This implies that weighted average= .2*80+.2*82+.2*85+.2*81+.2*88 = 83.2
Weighted average forecast for yen= 83.2

b.
Forecas
ter

RMS
E

Yen
Foreca
st

80

15

82

C
D
E

5
10
20

85
81
88

1/RMSE

0.1428
57
0.0666
67
0.2
0.1
0.05

Weights
=Wi

Composite forecast

25.5%
11.9% =25.5*80+11.9*82+35.7*85+17
.9*81+8.9*88 = 82.9
35.7%
17.9%
8.9%

This implies that the composite forecast= 82.9

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c. The composite forecast is a better measure of forecast as it takes into account

the different information from all the individual forecasters and then uses them on
weighted average giving more weightage to the traditionally accurate forecasters.
So the forecast in b that is the composite forecaste is better and accurate than in a.
The disadvantage is that it relies totally on weighted average of individual
forecasters.

E3:
Suppose you are evaluating two forecasters based on the following information.
Forecaster A made 30 "correct" forecasts of a total of 50 forecasts during the last
year. Forecaster B made 114 "correct" forecasts of a total of 200 forecasts during
the last year,.
a. What is the probability that forecaster A's track record of correct forecasts was
simply due to chance? (Note: you may use the normal approximation to the
binomial distribution.)
b. What is the probability that B's track record of correct forecasts was simply due to
chance? (Note: you may use the normal approximation to the binomial distribution.)
c. Discuss whether you would prefer to use the forecasts prepared by A or B.
Ans:
a. Number of correct forecasts=r=30
Total number of forecasts=n=50
P=r/n
P=30/50=.6
Standard error @(p)= (p(1-p)/n)^0.5
@(p)= (.6*.4/50)^0.5=0.0693
hypothesis

and P*=0.5 for null

Z=(p-p*)/@(p)
Z=(.6-.5)/.0693=1.443
b. Number of correct forecasts=r=114
Total number of forecasts=n=200
P=r/n
P=114/200=.
Standard error @(p)= (p(1-p)/n)^0.5
@(p)= (.57*.43/200)^0.5=0.035
hypothesis
Z=(p-p*)/@(p)

and P*=0.5 for null

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Z=(.57-.5)/.035=2
And this Z-score is statistically significant.
c. A has a better track record but the number of observations for A is small and
hence the probability of occurrence of that record is not significantly given by
his small saple size.
Where as B has a lessor track record of prediction than A but B has a better
sample size that 4 times of A and hence the probability of occurrence of the
forecast of B is significant and henceI would prefer to use the forecast
prepared by B.

E4:
As a multinational firm with sales in Japan, you require forecasts of the Yen/$
exchange rate. You have been using a professional forecasting firm, Crystal Ball
Associates, and now want to measure the performance of their predictions.
Following is a table showing the Crystal Ball forecasts, the actual end-of-period rates
and the one-period ahead forward rates.

Period
Crystal Ball Forecast (end of
period)
Actual spot rate (end of
period)

1
10
0
10
1

1-period forward rate

98

2
10
6
11
0
10
5

3
10
2
10
8
10
0

4
10
8
10
5
10
2

5
11
5
11
0
10
8

6
10
9
11
0
11
2

7
10
3
98
10
5

10

11

12

95

93

90

91

85

90

91

85

88

84

98

90

89

90

86

a. Calculate the performance of the Crystal Ball forecasts and the forward rate using
the MSE and RMSE method to measure their accuracy.
b. Calculate the performance of the Crystal Ball forecasts and the forward rate using
the percentage correct method to measure their usefulness.
c. Has Crystal Ball Associates demonstrated unusual forecasting expertise according
to the percentage correct method?
d. Compare your results using the two methods. What do you conclude?
Ans:
a.

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Period

Crystal Ball
Forecast (end
of period)

1
2
3
4
5
6
7
8
9
10
11
12

100
106
102
108
115
109
103
95
93
90
91
85

VIKAS KUMAR SINGH

Actual spot
1-period
rate (end of
forward rate
period)
101
110
108
105
110
110
98
90
91
85
88
84

98
105
100
102
108
112
105
98
90
89
90
86
MSE
RMSE

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Crystal Ball
(ActualForecast)^2

1-period
forward
(ActualForecast)
^2

1.00
16.00
36.00
9.00
25.00
1.00
25.00
25.00
4.00
25.00
9.00
1.00

9
25
64
9
4
4
49
64
1
16
4
4

14.75
3.84

21.083
4.59

b. Crystal Ball forecasts were on the right-side of the forward rate 10 times out of 12
months.
That is 10/12= 83.3%.

d. Crystal Ball forecasts have a percentage correction of 83.3%.

The probability of getting 10, 11 or 12 correct forecasts out of 12 (assuming
that the forecaster has no expertise) is (66+11+1)/4096 = 1.9%, so this is a
very rare and statistically significant event. The forecaster appears to have
significant expertise.
e. Crystal Ball forecasts are not much more accurate than the forward rate, but
they could be very useful if the firm has hedging decisions to make on a onemonth horizon.

HOMEWORK ASSIGNMENT 2

VIKAS KUMAR SINGH

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CME Case:
Q1:
What value is Vladimir Zelezny providing to TV Nova? What value is CME providing
to TV Nova?
Ans:
The values provided by Vladimir Zelezny to TV Nova are:
1. Local ownership
2. Presence within the political atmosphere of Czech Republic
3. Face of the TV for Czech audience
4. Worked as director providing the programs and features on television suited
to Czech audience.
The values provided by CME to TV Nova are:
1. Foreign capital necessary for media industry in Czech Republic
2. Expertize in operating media industry
3. Experience of operation from other parts of the Europe
Q2:
As CME, would you purchase the shares from Zelezny? If so, what would you worry
about? If not, what would you worry about? Please comment on how the (1) prior
and (2) proposed change in ownership structure affects incentives in this setting.
Ans:

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VIKAS KUMAR SINGH

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As CME, I would recommend not to buy the share from Zelezny, but would find local
partners, who would be good presence in the region and also counter the
dominance of Zelezny with their interest aligned to the interest of CME and try to
take the relationship of this new partner in Czech to international partnership or
CME could spin off a piece of CME to the Czech public to create more public support
for its interests.
Because if CME buys this share from Zelezny, it will create problems such as:
1. Conflict by the ownership, as this would give CME 99% ownership and this
would lead Czech media and people in a situation where they would question
CMEs intention of controlling TV nova. And the foreign ownership issue will
come to haunt the CME and they may be forced to sell some of the ownership
to parties they dont seem worthy for partnership.
2. By acquiring share from Zelezny, CME will have the ownership but not the
control as the control is exercised by CET 21 which is owned by Zelezny.