“WHAT DETERMINES THE EXCHANGE RATE

2. “What Determines the Exchange Rate: Economic Factors or Market Sentiment?” (Study

Session 4)

a) describe the monetary model of exchange rates;

b) explain why it is difficult to use the monetary model to forecast exchange rates;

d) evaluate the forecasting performance of approaches based on the monetary model and

news about economic fundamentals.

Guideline Answer:

Part A

Determine whether each of

the three conditions

Identify and describe the specific

supports or does not

component of the equity risk

Condition

support Ryan’s

premium associated with each of the

recommendation to use a

three conditions identified by Ryan

lower equity risk premium

(circle one)

Component: Income Return

Dividend yields are

expected to be well

below the historical

Description: Income return is the

Supports

average and

percent of market value distributed to

companies are

shareholders as cash during the

expected to buy

measurement period, or

back less stock

Does not support

D/P – ∆S

through share

D/P = dividend yield

repurchases.

∆S = % change in shares outstanding

Component: Repricing

Future financial and

technological

innovations will

Description: Repricing is the percent

continue to give

Supports

change in the P/E multiple over the

investors easier

access to the

financial markets

∆PE

and allow effective

Does not support

diversification of

risks.

Component: Nominal Earnings Growth

Real corporate

profits are expected

OR Real Earnings Growth OR Earnings

to grow steadily and

Growth

inflation is expected

Description (for Nominal Earnings

to be relatively

Growth or Earnings Growth): The sum

stable.

of the inflation rate and real earnings

Does not support

growth for the measurement period, or

i + g

OR

Real Earnings Growth is growth in

earnings net of inflation.

Supplementary information for Part A (not required of candidates):

Low dividend yields and smaller share repurchase would result in a lower income return and a

lower equity risk premium.

Such innovations would make investors willing to pay higher prices for a given stream of

earnings, which would contribute to an upward repricing going forward and a higher equity risk

premium.

Growing real corporate profit growth and stable inflation would contribute to greater nominal

earnings growth and a higher equity risk premium.

Part B

If incorrect, give one reason

why the statement is

the statements by Butler is

Statement

correct or incorrect

incorrect

“Because the monetary model

Real output is an important

focuses on money supply and

input to the monetary model,

exchange rate expectations,

Correct

along with money supply and

the model does not require

exchange rate expectations.

estimates of real output for the

Differences in real output

Incorrect

relevant countries.”

drive price levels, which

influence exchange rates.

“The monetary model has the

advantage of using input data

Correct Output data, money supply

data, and expectations are not

that are known with relative

known with certainty and/or

precision.”

subject to revision and/or

unobservable. This is actually

a disadvantage of the model.

LEVEL III, QUESTION 7

Topic: Portfolio Management-Individual Investor

Minutes: 25

Reading References: