Question
Assume that the following regression model was applied to historical quarter: ef= a0 + a1INTt +a2INFt-1 +u INTt= the average real interest rate differential (U.S.
Assume that the following regression model was applied to historical quarter:
ef= a0 + a1INTt +a2INFt-1 +u
INTt= the average real interest rate differential (U.S. interest rate minus the Euro interest rate) over period t.
INTt-1- inflation differential (U.S. interest rate minus Euro inflation rate) in the previous period.
a0, a1, and a2= regression coefficients
= error term
Assume that the regression coefficients were estimated as follows:
0= 0.0
1= 0.45
2= 0.28
Assume that the inflation differential in the most recent period was 2.85%. The real interest rate differential in the upcoming period is forecasted as follows:
Interest Rate Differential | Probability |
0% | 25% |
1% | 30% |
2% | 45% |
If a company uses this inflation to forecast the Euros exchange rate, what will be the probability distribution of the Euros percentage change over the upcoming period?
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