Forward versus Spot Rate Forecasts
Response to the following problem:
Assume that interest rate parity exists and it will continue to exist in the future. Kentucky Co. wants to forecast the value of the Japanese yen in 1 month. The Japanese interest rate is lower than the U.S. interest rate. Kentucky Co. will either use the spot rate or the 1-month forward rate to forecast the future spot rate of the yen at the end of 1 month. Your opinion is that net capital flows between countries tend to move toward whichever country has the higher nominal interest rate and that these capital flows are the primary factor that affects the value of the currency. Will the forward rate as a forecast result in a smaller, larger, or the same absolute forecast error as the use of today's spot rate when forecasting the future spot rate of the yen in 1 month? Briefly explain.