18 probability distribution of forecasts assume that the following regression model 4140880

18.   Probability Distribution of Forecasts. Assume that the following regression model was applied to his- torical quarterly data:

et  = a0  + a1INTt  + a2INFt1  + mt

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

INTt = average real interest rate differential (U.S. interest rate minus Japanese interest rate) over period t

INFt-1 = inflation differential (U.S. inflation rate minus Japanese inflation rate)

in the previous period

a0, a1, a2 = regression coefficients

mt = error term

 

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

a= .0

a1 = .9

a= .8

Also assume that the inflation differential in the most recent period was 3 percent. The real inter- est rate differential in the upcoming period is fore- casted as follows:

 

Interest Rate Differential

 

Probability

0%

30%

1

60

2

10

 

If Stillwater, Inc., uses this information to fore- cast 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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