IRP, Expectations, and Forecast Error
Response to the following problem:
Assume that interest rate parity exists and it will continue to exist in the future. Assume that interest rates of the United States and the United Kingdom vary substantially in many periods. You expect that interest rates at the beginning of each month have a major effect on the British pound's exchange rate at the end of each month because you believe that capital flows between the United States and the United Kingdom influence the pound's exchange rate. You expect that money will flow to whichever country has the higher nominal interest rate. At the beginning of each month, you will either use the spot rate or the 1-month forward rate to forecast the future spot rate of the pound that will exist at the end of the month. Will the use of the spot rate as a forecast result in smaller, larger, or the same mean absolute forecast error as the forward rate when forecasting the future spot rate of the pound on a monthly basis? Explain.