Why is it necessary to consider forecasts of real currency appreciation and depreciation when doing an international capital budgeting analysis?
What will be an ideal response?
The most important reason to consider forecasts of real currency appreciation or depreciation is that it is likely that a change in the real exchange rate will affect the cash flows of the project. Remember that a real depreciation of the domestic currency makes domestic exporters more profitable and domestic importers less profitable. Also, real appreciations typically reverse themselves somewhat slowly, so that knowledge of the current situation is necessary to know whether the future expected changes in the real exchange rate are going to enhance or detract from the cash flows of the project. Finally, if forecasts of nominal exchange rates are being made with uncovered interest rate parity, these will be somewhat different than forecasts based on relative purchasing power parity. If the market thinks that there will be a real appreciation or depreciation in the future, forecasts of nominal exchange rates based on relative purchasing power parity will not be correct.
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