19 Probability distribution of forecasts. Assume that the following regression model was applied to

 

19      Probability distribution of forecasts. Assume that the following regression model was applied to histori- cal quarterly data:

et ¼ a0 þ a1INTt þ a2INFt–1 þ mt

where

et ¼ percentage change in the exchange rate of the Japanese yen in period t


 

INTt            ¼ average real interest rate differential (UK interest rate minus Japanese interest rate) over period t

INFt21 ¼ inflation differential (UK inflation rate minus Japanese inflation rate) in the previous period

a0, a1, a2 ¼ regression coefficients

mt                ¼ error term.

Assume that the regression coefficients were esti- mated as follows:

 

a0  ¼ 0:0

a1  ¼ 0:9

a2  ¼ 0:8

Also assume that the inflation differential in the most recent period was 3%. The real interest rate differen- tial in the upcoming period is forecasted as follows:

 

Interest Rate Differential

Probability

0%

30%

1

60

2

10

 

If Stillwater Ltd uses this information to forecast the Japanese yen’s exchange rate, what will be the probability distribution of the yen’s percentage change over the upcoming period?

 

 
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