Group Assignment

Presented by

Institution

Subject

Date

Plot the collected FX data on a graph showing the daily movements

Figure 1: Daily FX exchange rates for different currencies

Select three currencies (from the given) and find the significant movements of FX rates during the period and explain possible reasons for those movements (you are required to cite all your information sources).

The selected currencies are US dollar, UK Pound, and Chinese Yuan. To start with, the US Dollar has shown a tremendous increase within the period of between July 1 2010 and July 1, 2012. As shown in figure 1, the rate was low in July 2010 but increased with a very high rate to June 2012. The AUD and USD exchange rate shows the relationship between toe currencies in respect to daily FX exchange rates. The USD exchange rate appreciated by 0.14% during the first 100 days from July 2010. The FX rate averaged 1.1in July 2011 and showed a low record of 0.48 in April 2012. The upward move was driven mainly by the AUD weakness when the minutes of most reserve banks in Australia were released. The bank’s committee anticipated the Australian economic growth that went below the normal trend increasing the daily value of the US dollar. This made RBA investors to cut domestic interest rates in late 2012 (ADB (Federal Reserve 2013).

On the other hand, the UK Pound showed a good relationship with the AUD over the two years period. The UK interest rates rise relatively because of the stable economy experienced in the country. The high interest rates charged on good in UK in between January and June 2012 lead to currency depreciation forcing the Australian dollar to overtake UK pound. The United Kingdom accepted majority recommendations introduced by the independent commission on banking. One of the recommendation included increasing capital requirements in order to save commercial banks from wholesale banking groups. The UK pound accelerated by 0.12% between the July 2010 and December 2011. On the other hand, the global equity prices fell by 9% in 2011 across all currencies causing a balanced exchange between UK pound and Australian dollar (Asian Development Bank 2013).

Finally, the Australian dollar and the Chinese Yuan showed an interesting relationship during the two years period. The Chinese Yuan showed a little bit of success over the Australian dollar in terms of interest rates because the currency was not much affected by inflation. China kept stabilizing its economy between December 2010 and June 2012 that made its currency to shoot. On the other hand, Australia invited many investors to its location who contributed more to its economic expansion. The main reason for introducing investors was to fight back into Chinese Yuan that has dominated most assets in the country. Australia introduced more than 150,000 new jobs that made its economy to increase by 1.6% by 1 June 2012.

Assume that you have invested AUD 1,000,000 in each country on 1st July 2012. Estimate the AUD value of each investment as at 30th September 2012, 31st December 2012, 31st March 2013 and 30 June 2013. Explain how the foreign exchange rates affected to change the value of those investments. Are there any other factors which can affect to the AUD value of those investments? Suggest possible strategies that investors can use to reduce the possibility of unfavorable value changes on foreign exchange rate change.

The amount invested in each country is AUD 1,000,000 on 1st July 2012. Table 1 shows the respective estimated AUD value for each investment. The following formular will be used:

VI1 = PV(1 + I)t …….. (1)

Where, VI is the value of investment,

PV is the amount invested

I is the interest rate, and

t is the period of investment

for United States, I = 5% hence,

VI = 1000000(1+0.05)3/12

= 1,037,222.39

Country

US

(USD) Japan

(JPY) UK

(GPB) Thailand

(THB) China

(RMB) India

(INR)

30 sep 2012 1,037,222.39 1,022,188.28. 1,052,452.61 1,048,626.55. 1,022,188.28. 1,019,949.94.

31 Dec 2012 1,050,241.77. 1,040,012.13. 1,070,978.18. 1,065,759.20. 1,022,215.15 1,024,995.95

31 March 2012 1,102,787.04. 1,253,325.23 1,095,885.32 1,114,256.89 1,085,524.10 1,325,256.05

30 June 2012 1,236,145.02 1,258,856.36 1,125,552.41 1,365,895.00 1,124,114.30 1,589,968.36

Foreign exchange rates have a significant impact on the value of investment in each country. A stable interest rate is responsible for attracting a uniform investment any amount of money in any country. On the other hand, the international trades for example, influence the currency interest rates that in return affect the amount of investment a person makes. For example, countries relying on exports find their products very competitive in the international markets due to fluctuation of exchange rates. Exchange rates have a direct effect on the realized return on investment. A person owning a stock in a foreign country, for instance Japan, where local currency goes up by 10% within two months increases his value of investment by 10% irrespective of the stock price. On the other hand, balance of trade has an effect on the foreign exchange rate. Imports and exports are the major contributors to balances of trade and capital. The amount of interest rate charged in a country affects the exchange rate between the two countries leading to an effect on the value of investment (Agar 2005).

Other factors apart from foreign exchange rates also affect the amount of AUD on these investments. Firstly, the amount of interest charged on the investment affects the amount acquired at the end of a specified period. For instance, the person invested AUD 1,000,000 for a period of 2 months in US at an interest of 5% per annum. The value of interest affected the value of investment because the amount invested in US at an interest of 5% was lower than amount invested in UK at an interest of 7.5% p.a. Secondly; credit risks affect the value of investment after a given period. The value of investment depends on the credit quality and the ability to meet all the financial obligations of the invested country. Countries with low credit ratings offer higher yields to investors to cater for additional credit risks. In addition, a change in the country’s credit rating and marketing perceptions affect the value of outstanding investments (Damodaran 2002).

Investors can reduce the possibility of unfavorable value changes on foreign exchange rate change through the following means. To start with, a country needs to identify and measure the foreign exchange exposure that it can manage. The focus of a country should b on investment risks. For a country like US, the measure of exposure will involve determining the difference between the expected U.S. dollars to be received over the given period and the amount required to make payments. The difference determines the exposure of such country to value changes of foreign exchange rates that can be minimized to get more value on investments. Secondly, the country should develop a foreign exchange policy that helps in determining tools and instruments to be used under various circumstances. On the other hand, a country can split accounting in order to qualify for hedging.

Estimate the correlation coefficient for each pair of currency. What can you learn from the estimated correlation coefficients? Assume that you have engaged in export and import of finish goods and raw material from these countries. Explain, how can you use the estimated correlation coefficient to manage cash flow positions of your business

The correlation coefficient between each pair of currencies is shown below.

…………….(Forex Trading Zone 2013)

For AUD and USD,

r = (0.5-0.32)(0.7-0.55)/(0.0324*0.0225) = /0.027

= 0.13

Table 2 shows correlation for other pairs

Currency Correlation coefficient

US 0.13

JPY -0.2

GBP 0.52

THB 0.42

RMB 0.11

INR -0.5

Table 2: Correlation coefficient of UAD and other currencies

From the estimated correlations, it is clear that the value of correlation depends on the amount of foreign exchange rate of a currency. Currencies with negative correlation values have a high degree of negative correlation while those with positive values of correlation show that the data has reached a negative lock step. The following estimated value of correlations could be used in managing cash flow positions of a business. To start with, businesses introduce many international transactions that are generated by the ever-growing enterprises and countries. In order to manage such businesses effectively, it is recommended that all businesses be conducted using the home currency. When all customers are restricted to pay using same currency, it reduces risks of losses and the burden of currency fluctuations. In addition, those correlations with negative values should be avoided because they indicate unstable foreign exchange rates that can lead a business into losses. On the other hand, positive coefficients show a promising investing place but the manager should also consider the currency stability of that country before engaging in any business (Clarida, Davis & Pedersen 2009).

Based on the spot exchange rates on 1st July, 2012, estimate the expected exchange rates for USD, INR, RMB and MYR in six months and one year using the purchasing power parity (PPP) and the International Fischer Effect (IFE).

The purchasing power parity (PPP) relates a change in two countries expected inflation rates to change in exchange rates. PPP is calculated from the following formula:

S1/S0 = (1 + Iy) / (1 + Ix)

Where, S1 = the spot exchange rate at the end of time period

S0 = spot exchange rate at the beginning of time period

Iy = expected annual inflation rate of country Y

Ix = Expected annual inflation rate of country X.

From the formula, the expected exchange rates for US can be calculated as:

Six months S0.5 = (1.2) x 0.978 = 1.16.

One year S1 = 1.2 x 0.489 = 0.586

Table 3 shows estimates for other currencies.

Currency 6 months One year

US 1.16 0.58

JPY 1.25 0.23

GBP 2.3 0.33

THB 0.5 0.92

RMB 1.33 0.25

INR 2.55 1.00

Compare your estimated spot exchange rates with corresponding actual rates.

Explain why they are different to corresponding actual exchange rates

Comparing the estimated spot exchange rates and actual rates indicates a huge difference. The actual rates are higher than the estimated spot exchange rates. To start with the behavior of spot exchange rates shows that there was a random walk with a little drift. The monthly standard deviation of exchange rates between two currencies, AUD and USD was about 1.4% per month, and changes of more than 2% occurring in moderate frequencies. The changes in national price levels measured from consumer price indices contributed to the achieved differences. Secondly, there was a relationship between currency correlations and forward exchange rate for currencies maturing after one year. They indicated that spot and forward rates almost moved in the same direction and approximately same amount. Thirdly, the law of purchasing power parity requires a close correspondent between normal exchange rates and estimated exchange rates, but it was not the case. In a six months’ period, the different was huge enough to differ with this rule because of changes in consumer indices ratios (Dothan & Ramamurtie 2012).

Using your findings explain whether there were any possibility to make a profit on arbitrage or on speculations in the FX market during 2012/13.

From the above findings, there were very high possibilities of making profits on arbitrage in the FX market during 2012/2013. This is because the fluctuating foreign exchange gave investors an opportunity to invest in countries whose currencies were high and had no intention of dropping. In addition, the low interest rates charged in Australia gave investors a higher chance of acquiring more profits before the dollar destabilizes.

References list

ADB (Asian Development Bank). (2013). Asian Development Outlook 2013: Asia’s Energy

Challenge. Manila.

AGAR, C. (2005). Capital investment & financing a practical guide to financial evaluation.

Oxford: Elsevier Butterworth-Heinemann.

CLARIDA, R. H., DAVIS, J., & PEDERSEN, N. (2009). Currency carry trade regimes beyond

the fama regression. Cambridge, MA: National Bureau of Economic Research.

DAMODARAN, A. (2002). Investment valuation: tools and techniques for determining the

value of any asset (2nd ed.). New York: Wiley.

DOTHAN, M. U., & RAMAMURTIE, S. (2012). Applying economic restrictions to foreign

exchange rate dynamics: spot rates, futures, and options. Atlanta, Ga.: Federal Reserve Bank of Atlanta.

FEDERAL RESERVE. (2013). Price-adjusted Broad Dollar Index. Washington:

Federal Reserve.

FOREX TRADING ZONE. (2013). Correlation Between Currencies. Retrieved from:

http://www.forextradingzone.org/articles-Currency_Correlation