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Answer: The value of a country's currency will be negatively correlated with a factor representing changes in that country's money supply.
## Explanation Option D is correct because: - **Money Supply Impact**: When a country increases its money supply, this typically leads to inflationary pressures and can devalue the currency relative to other currencies, creating a negative correlation. - **Economic Theory**: According to monetary theory and purchasing power parity, an increase in money supply (all else equal) tends to decrease the value of a currency. - **Factor Model Relevance**: This relationship is empirically supported and represents a fundamental economic factor that should be considered in FX risk modeling. **Why other options are incorrect:** - **Option A**: Using more factors doesn't guarantee accurate predictions and can lead to overfitting. FX markets are highly efficient and difficult to predict consistently. - **Option B**: While political stability can influence interest rates, it's not the most important factor. Central bank policies, inflation expectations, and economic growth are typically more direct determinants. - **Option C**: FX rates for developed countries are not constant even for short periods; they fluctuate continuously due to market forces, economic data releases, and other factors. This factor model consideration aligns with fundamental economic principles in currency valuation and risk management.
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A quantitative analyst at a foreign exchange (FX) trading company is developing a new factor model to be used for estimating potential risk exposures on FX trades. The analyst is evaluating potential factors to use in the model, and their effects on the performance of the model. Which of the following statements is most likely correct for the analyst to consider when developing the model?
A
Using a large number of underlying factors will allow the model to correctly predict future exchange rates.
B
The most important factor in predicting a country's interest rates is the political stability of the country.
C
The pair-wise exchange rates for currencies of developed countries can be assumed to be constant for terms shorter than 3 months.
D
The value of a country's currency will be negatively correlated with a factor representing changes in that country's money supply.
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