| Course | BUS 553 Global Corporate Finance |
|---|---|
| Module | Module 4 |
| Paper type | Exchange rate analysis |
| Length | About 1,061 words, 6 pages |
| Format | APA 7 student paper |
| School | Aspen University |
| Program | MBA |
| Updated | October 2026 |
Free sample paper for BUS 553 Module 4
Why No One Can Forecast the Euro, and What a Budget Should Use Instead: Parity Conditions for an Apparel Company
Student Name
MBA Program, Aspen University
BUS 553: Global Corporate Finance
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Month Day, Year
Why No One Can Forecast the Euro, and What a Budget Should Use Instead: Parity Conditions for an Apparel Company
Willamette Trail Outfitters, a composite company in Portland, Oregon, designs rain jackets, hiking pants and packs. About 30% of its revenue comes from European outdoor retailers, which it invoices in euros, about 48 million euros a year. Each fall, the company sets its budget for the coming year, and it must choose an exchange rate to convert expected euro sales into dollars. Last year, the sales team used a bank's optimistic forecast, the euro weakened instead, and the company missed its profit target. The chief financial officer wants a better approach. This paper examines what determines exchange rates and what that implies for the budget.
The Parity Conditions
Krugman et al. (2018) explain three relationships that link exchange rates to prices and interest rates. Under purchasing power parity, currencies drift over the years until a shared basket of goods carries one price wherever it is bought; if U.S. inflation exceeds euro area inflation, the dollar should weaken against the euro by roughly the difference. Interest rate parity holds that the forward exchange rate reflects the difference between two countries' interest rates, so that an investor cannot earn a riskless profit by borrowing in one currency, converting, lending in another and locking in the return with a forward contract. The international Fisher effect links the two, predicting that currencies with higher interest rates, reflecting higher expected inflation, will tend to depreciate.
Deriving the Forward Rate
For illustration, the spot rate is 1.10 dollars per euro, the one-year U.S. interest rate is 4.0% and the one-year euro rate is 2.2%. Covered interest parity implies a one-year forward rate equal to the spot rate times 1.040 divided by 1.022, or about 1.12 dollars per euro. The euro trades at a forward premium because euro interest rates are lower. This forward rate is not a forecast made by anyone; it is the rate at which Willamette can actually lock in conversions today.
Purchasing power parity points in the same direction over the long run. With expected inflation of 2.8% in the United States and 2.0% in the euro area, purchasing power parity suggests the euro would strengthen by about 0.8% a year, to roughly 1.11 dollars.
Can Anyone Forecast the Euro
Meese and Rogoff (1983) tested whether economic models of exchange rates, based on money supplies, incomes, interest rates and trade balances, could forecast exchange rates better than a random walk, the simple assumption that the future rate will equal today's. Even when they gave the models the actual future values of the economic variables, the models did no better than the random walk at horizons of up to a year. Decades of later research have largely confirmed that short-run exchange rates are very hard to forecast.
Is the Forward Rate a Good Forecast
If forecasting is so hard, perhaps the forward rate is the market's best forecast. Fama (1984) tested this and found that forward rates did not behave as unbiased predictors of future spot rates; the evidence suggested that forward rates contain a varying risk premium as well as expectations. Currencies with higher interest rates often did not depreciate by as much as the forward rate implied, and sometimes appreciated. The forward rate, then, is not a reliable forecast either, but it has one decisive advantage for a business: it can be locked in.
What Drives the Euro in Practice
Over months and years, the euro responds to differences in interest rates set by the Federal Reserve and the European Central Bank, to growth and inflation in the two economies, to energy prices, which matter greatly to Europe as an importer, and to shifts in investors' appetite for risk, which often strengthen the dollar in turbulent periods. Each of these is itself hard to forecast, and their combined effect on the exchange rate is harder still. That is the practical reason economic models struggle: even a correct model needs inputs that cannot be known in advance.
The Cost of Hedging
Some managers believe hedging is expensive. For Willamette, selling euros forward at 1.12 when the spot rate is 1.10 is not a cost; the forward rate is higher because euro interest rates are lower. The real costs are bank margins, which are small for a company of Willamette's size, and the opportunity cost of not benefiting if the euro rises above 1.12. Against these, hedging removes most of the budget risk that cost the company its profit target last year.
Comparing Budget Rates
The bank's forecast produces the most attractive budget but cannot be locked in and, given the evidence, has little claim to accuracy. The past average reflects conditions that have changed. The spot rate is a reasonable forecast but ignores the interest differential that determines the forward rate.
| Candidate rate | Dollars per euro | Euro sales of 48 million converted | Basis |
|---|---|---|---|
| Today's spot rate | 1.10 | $52.8 million | Random walk assumption |
| One-year forward rate | 1.12 | $53.8 million | Tradable today |
| Bank's forecast | 1.18 | $56.6 million | Economic view, unhedgeable |
| Average of past twelve months | 1.08 | $51.8 million | Backward-looking |
Sales Teams and Budget Rates
Last year's miss also had an organizational cause: the sales team chose the rate, and a favorable rate made its targets easier to meet. Setting the budget rate centrally, from the market, removes that temptation. It also lets the company judge European sales managers on the euro volumes they control rather than on currency movements they do not.
Recommendation
Willamette should use the one-year forward rate as its budget rate, because it reflects current market prices and can be secured. It should hedge about 60% of expected euro sales with forward contracts at that rate, leaving room for differences between forecast and actual sales. The unhedged 40% will vary with the euro, and the budget should report the profit effect of a 5% move in either direction so that managers understand the remaining exposure.
Conclusion
Parity conditions explain how exchange rates relate to prices and interest rates, but research shows that short-term rates cannot be forecast reliably by models, and forward rates are not unbiased predictions. A company that cannot forecast the euro should not budget as if it could. Using the forward rate and hedging part of the exposure turns an unanswerable forecasting question into a decision the company can control.
References
Fama, E. F. (1984). Forward and spot exchange rates. Journal of Monetary Economics, 14(3), 319-338. https://doi.org/10.1016/0304-3932(84)90046-1
Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International economics: Theory and policy (11th ed.). Pearson.
Meese, R. A., & Rogoff, K. (1983). Empirical exchange rate models of the seventies: Do they fit out of sample? Journal of International Economics, 14(1-2), 3-24. https://doi.org/10.1016/0022-1996(83)90017-X
Reading the BUS 553 Module 4 assignment instructions
The Aspen catalog lists the forces affecting relative currency prices as a central subject of BUS 553, and this module usually asks students to apply parity conditions and think critically about forecasting exchange rates. The instructions in your classroom determine the exact task; this example uses the parity conditions to set a budget rate. Explain purchasing power parity, interest rate parity and the international Fisher effect, including what each predicts. Use current or clearly stated interest and inflation rates to derive implied rates. Review research on how well exchange rates can be forecast. Compare candidate forecasts for a business purpose. Recommend a practical approach and explain how it reduces the effect of forecasting errors on the business.
How this BUS 553 Module 4 example is built
The paper opens with Willamette Trail Outfitters and its sales to European retailers priced in euros. Krugman, Obstfeld and Melitz's text supplies the parity conditions. A section derives a one-year forward rate of about 1.12 dollars per euro from a spot rate of 1.10, a U.S. rate of 4.0% and a euro rate of 2.2%. Purchasing power parity, using expected inflation of 2.8% in the United States and 2.0% in the euro area, gives a similar long-run direction. Meese and Rogoff's Journal of International Economics article shows that structural models failed to beat a random walk out of sample. Fama's Journal of Monetary Economics article shows that forward rates have not predicted future spot rates as theory implies. A table compares the spot rate, the forward rate, a bank's forecast and the average of the past year. The recommendation budgets at the forward rate and hedges 60% of expected sales.
BUS 553 Module 4 rubric: what earns full marks
Parity papers are marked on correct statement of the conditions, accurate calculation of implied rates, critical use of evidence on forecasting and a sensible business recommendation. This example states each parity condition and what it predicts, derives the forward rate step by step from stated rates so the grader can reproduce it, and checks the result against purchasing power parity. Meese and Rogoff's Journal of International Economics study and Fama's Journal of Monetary Economics article supply the evidence that forecasting is extremely hard, which is the analytical core of the paper. Krugman, Obstfeld and Melitz's text supports the definitions. The recommendation responds to the evidence rather than ignoring it: since no forecast is reliable, the company budgets at a rate it can lock in and hedges to reduce the cost of being wrong.
BUS 553 Module 4 help: mistakes that cost marks
Students often treat parity conditions as forecasts that will come true, then build budgets on them with confidence. Explain what each condition predicts and what the evidence says about how well it holds. Another error is stating exchange rates without a consistent convention; state whether you quote dollars per euro or euros per dollar and keep it throughout. Show the forward rate calculation with the interest rates used. Distinguish short-run forecasting, where models do poorly, from long-run tendencies such as purchasing power parity. Avoid choosing a bank's forecast simply because it looks precise. Finally, connect your conclusion to a business practice, such as using the forward rate as a budget rate and hedging, that reduces the damage forecasting errors can do.
Write yours, or have the desk draft it
This paper is an original model document written by our desk, not a submitted student paper and not an official Aspen University document. Read it for the moves, then write your own to the instructions in your classroom. If you want one built to your exact prompt and rubric, the first custom sample is free and arrives in 24 to 48 hours.
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BUS 553 Module 4 questions, answered
What does BUS 553 Module 4 usually ask for?
Aspen's BUS 553 covers exchange rate determination and parity conditions in this module, so applying parity relationships and evaluating currency forecasts for a business decision is typical. Follow your classroom prompt.
What is interest rate parity?
The condition that the forward exchange rate reflects the difference between two countries' interest rates, so that investors cannot earn riskless profits by borrowing in one currency and lending in another.
Can exchange rates be forecast accurately?
Research beginning with Meese and Rogoff found that economic models forecast short-term exchange rates no better than assuming no change, so forecasts should be used with great caution.
Where can I find a free BUS 553 Module 4 sample paper?
The complete analysis is shown above: an apparel company choosing a euro budget rate with parity conditions, a forward rate, research on forecasting and a table of candidate rates.
What is the forward premium puzzle?
The finding, documented by Fama, that forward rates have not predicted future spot rates as theory implies, with high-interest currencies often failing to depreciate as expected.