QUESTION

BAO 3402 INTERNATIONAL BANKING AND FINANCE

Weight  : 20% of Final Exam

GROUP ASSIGNMENT
DUE DATE : May 18, 2012

Group Composition: Minimum 2 to Maximum 4 students
You allowed to select your own group from the tute class you are assigned in. If you
are not able to join with a group, you must contact your tutor before week 6 tutorial.
Each group is required to maintain a record of group meetings which should be
attached with their final report. Inability to submit the record will cost you 10% of
your earned marks on the assignment. You can arrange your meetings during the first
10 minutes of your tute class. You can seek the support from your tutor if required.

Introduction

FX market is considered as the most perfect market in the world where we can expect to hold
the law of one price. The law of one price provided theoretical base for all international parity
conditions. International parity conditions can be used to understand the operational
behaviour of the foreign exchange market. In a perfect market, all these parity conditions
should be held and there will be no possibility of abnormal profit on arbitrage or speculation.
The aim of this group assignment is to give you an opportunity to empirically investigate the
existence of some of those parity conditions.
This assignment consists of two tasks, as described below:

Task one: Factors affecting the foreign exchange market – (10% Marks)

1. You are required to collect data on historical foreign exchange rate  for 10 selected
currencies against the Australian dollar (see the attached link for sources of historical
FX rates) for the period of 01/02/2011 -29/02/2012 (one year).
2. Plot the collected data on a graph showing the daily movements in FX rates (you can
plot all data in one chart or use several charts, if the magnitude of the rates varies
widely).
3. Identify the significant movement of FX rates during the last year of your data and
explain possible reasons for those movements (you are required to cite all your
sources).
1

4. Discuss how those foreign exchange movements have affected the economy in
general (you can use any other information such as trade statistics to justify your
explanations).
5. Estimate the correlation coefficient for each pair of currency. What can you learn
from the estimated correlation coefficients? Explain, how you (assuming that you are
a financial controller of a large MNC which having cash flows in all currencies) can
use the estimated correlation coefficient to manage the foreign exchange rate
exposure.
Task two: Forecasting foreign exchange rates (10% Marks)

1. Select five currencies on which you have already collected data and find
corresponding national interest rates and inflation rates information from respective
official sources (such as reserve banks or IMF).
2. Based on the spot exchange rates on 1
st
February, 2011,  estimate the expected
exchange rates for each currency units in one month, three months, six months and
one year using the power purchase parity and International Fischer Effect.
3. Compare your estimated spot exchange rates with the corresponding actuals rates. Are
they different to the actuals? Explain why.
4. Using your findings explain whether there were any possibility to make a profit on
arbitrage or on speculations in the FX market.
Your findings should be presented as a report. All sources of information (such as bank
names, text books, websites with addresses, etc) which you used to prepare your report
should be cited appropriately.     (You must attach the FX data tables and other relevant
graphs with the soft copy of your report).
(Word requirements for the report–2,000 (Maximum/excluding statistical data))
Submission:
The soft copy and the printed copy of the completed report should be submitted on or before
May 18, 2012. The soft copy should be in Ms-word (PDF files are not accepted).
You are not required to attach data tables with your printed copy. All data tables should be
attached to the soft copy of the main report. Inability to provide soft copy will cost 50% of
your earned marks. The soft copy of the assignment should be uploaded using the assignment
drop box in the webCT.
The file name of soft copy must consist of subject code followed with your ID numbers.
(Eg. BOA3402_378XXX_365CCC_380TTT_1234YY.DOC).
Useful websites
http://www.westpac.com.au/
2

http://www.commbank.com.au/
www.bloomberg.com
www.ozforex.com.au
WWW.CME.COM
www.dailyfx.com
www.forextrading.com.au
http://www.oanda.com
http://www.rba.gov.au/statistics/hist-exchange-rates/index.html
http://www.imf.org/external/data.htm
http://www.imf.org/external/data.htm

SOLUTION

Part 1:1. Introduction

Floated in 1983 the Australian dollar rate has been determined by the forces of demand and supply in the economy. In the past decade the Australian dollar has experienced considerable appreciation with the Australian economic boom owing to the export growth. This has led to the improvement in the terms of trade between Australia and other countries. The paper examines the trends in the Australian dollar appreciation over the past one year and compares it with other currencies. It is interesting to note that the currencies under consideration like the USD, Pound (GBP), Euro, Ringa , Yen and the Chinese RMB the Australian dollar has appreciated against all the currencies. In the paper we consider 2 currencies the Euro and the GBP and examine the trends of appreciation of the Australian dollar.

2. Trends in the Australian Dollar Appreciation

Over the past few years the Australian dollar has made considerable appreciation owning to the consistent performance of the Australian economy. But However over the last year the Australian dollar has experienced considerable depreciation, and is finally feeling the impact of the financial crisis. Thus, the one year trends in the foreign exchange movement of different currencies in comparison with the Australian dollar have been listed below.

Figure 1 : Moverment in USD in 2011(www.rba.gov.au – acsssed on 4/5/2012)

Figure 2 : Movement in the Chineease RMB in 2011 (www.rba.gov.au – acsssed on 4/5/2012)

Figure 3 : Movement in Japanease Yen 2011(www.rba.gov.au – acsssed on 4/5/2012)

Figure 4:Movement in the Euro 2011 (www.rba.gov.au – acsssed on 4/5/2012)

Figure 5: Movement in the Singapore Dollar  2011(www.rba.gov.au – acsssed on 4/5/2012)

Figure 5 : Movement in the GBP in 2011(www.rba.gov.au – acsssed on 4/5/2012)

Figure 6 : Movement in the New Zealand Dollar (www.rba.gov.au – acsssed on 4/5/2012)

Figure 7: Movement in the Vietnamease Dong in 2011 (www.rba.gov.au – acsssed on 4/5/2012)

Figure 8 : Movement in the Thai Bhat 2011(www.rba.gov.au – acsssed on 4/5/2012)

3. Movements in the Forign Excahange Market and the Effects on the Australian Economy

The Australian economy is finally feeling the impact of the financial crisis, this is evident in the exchange rate fluctuations of the Australian dollar in comparison to the other currencies. After experiencing considerable appreciation in the currency over the past decade; owning to the robust growth of the Australian economy has been due to the growth of the Australian exports. Australia has been effectively able to capitalise on the competitive advantage that is possesses in terms of rich mineral deposits. Another reason that can be identified for the appreciation of the Australian dollar is the higher commodity exchange prices; this resulted in countries buying large amounts of Australian currency, leading to the Australian currency appreciation (RAVIMOHAN, 2010). The Australian dollar was expected to surpass its previous highs of the past in 2011 largely attributed to the rising coal and commodity prices (www.bloomberg.com – accessed on 4/5/2012).

The recent volatility in the Australian exchange rate and the Australian economy cannot be ignored this has been largely due to the dependence on the export growth. The Australian governments increased pressure on the RBA to cut rates may further introduce volatility and jeopardise the growth process. Therefore it is important that the movement of the exchange rate be tracked such that it is not able to affect or jeopardise the growth of the Australian economy.

(www.halofinancial.com- accessed on 4/5/2012).

Part 2: 1. Interest Rates and Inflation Rates

The interest rates and the inflation rates of the following countries are

1. United States of America (USD) The Inflation rate determined by the FED 3.1% (2011) while the interest rate determined is 0.5%
2. United Kingdom (GBP) The Inflation rate calculated by the Bank of England for year ended 2011 is 4.5% while the interest rate that has been determined at 0.5% to keep the inflation levels under check.
3. Singapore: The inflation rate of the Singapore economy for the year ended 2011 is 3.9% while the rate of interest for the same period determined by the central bank of Singapore 0.56%.
4. China :the inflation rate of the Chinese economy for the year ended 2011 is 4.1 % while the rate of interest is at 6.5%
5. Thailand: The inflation rate of the Thai economy for the year ended 2011 is 3.35% while the rate of interest for the economy determined by the bank of Thailand is 3.25%.

(IMF.com, Monitory Authority of Singapore – MAS, Bank of Thailand, and Bank of England, Trading economics.com – accessed on 4/5/2012)

3. Fisher Effect and PPP

3.1 Fisher Effect Exchange Rate Calculations

The fisher Effect Equation is

Ef=1+Ih/(1+If)-1

(Madura, 2008)

Thus Applying the Fisher Effect Formula we have, the exchange rate of the Australian Dollar vs the other currencies for a period of 1 month, 3 months and 6 months

(IMF.com, Monitory Authority of Singapore – MAS, Bank of Thailand, and Bank of England, Trading economics.com – accessed on 4/5/2012, Nguyen , 2005 )

3.2Purchasing Power Parity Calculations

According to the Purchasing Power Parity the Law of one price holds therefore implying that the Price in the home country is equivalent to the prices in the foreign country. This can be explained further as suppose that a basket of goods is being is being traded in Australia to the US then according to the PPP theory the price of goods in Australia is equal to the price of goods in the US.

Mathematically the equation can be read as

Price of Goods in Australia = Price of goods in US x Exchange rate

Therefore Price of goods in Australia / Price of goods in US = Exchange Rate

Therefore applying the theory in the calculations of exchange rate are :

(IMF.com, Monitory Authority of Singapore – MAS, Bank of Thailand, and Bank of England, Trading economics.com – accessed on 4/5/2012, Nguyen , 2005 )

Therefore According to the PPP the exchange rates should be the following but however are not the same

Figure 8 : Spot Rates of the Australian Dollar on 1/2/2012(www.rba.gov.au – acsssed on 4/5/2012)

Thus the results obtained from the calulations of the PPP and the actual spot rates are very different , this is because the PPP theory assumes very simplistic assumptions which often do not apply in the real world.

The main weaknesses of the PPP theory are

1. Firstly the law of one price ignores transporatation costs and assumes them to be 0 , this however is not the case in the real world where high tranporation costs exist , hence there is a difference in the exchange rate determination.
2. Secondly, The PPP theory ignores the cost of untadable goods such as in some countries high protectionist policies may be followed imposing high entry costs , these costs are bot accounted in the PPP theory and therefore leads to inconsistent exchange rate determination.
3. Thridly , Aysmetric information in the foirgn exchange market is also the cause of the inconsistent PPP calculations. As policies of one country may be unknown to the other and therefore the differences in the costs arise leading to PPP differences.

Thus with the inherent weaknesses in the PPP, the actual exchange rate cannot be determined using this law as it ignores certain basic practical applications.

(Nguyen , 2005)

4. Speculation and Artbitrage

The speculators try to ensure based on the back and forth movement of the foreign exchange market. The speculators try to predict the foreign exchange market to make gains based on the current economic conditions and the interest and exchange rate data availability. From the above data certain speculative gains can be made by the speculators on currencies like the USD and the GBP, accounting for the PPP calculations and the spot calculations are quite accurate. Moreover the policies have suggested that the upward movement of the Dollar and Pound would continue, therefore the risk can be taken. Speculation is a highly risk based activity the individual involved should ensure some hedging while taking these risks by entering into future contracts.

On the other hand arbitrage, is based on the prices in the foreign exchange market which are risk free and difficult to predict. If the price of the futures contract converges with the spot rate the Arbitrage opportunities increase. The Arbitrage gives the investors the choice to purchase the asset or not. Therefore owning to the current market scenario and with most economies trying emerging out of the financial crisis arbitrage opportunities are better than speculation.

5. Conclusion

The foreign exchange market is described as the most perfect market; this however is not the case. The market may be perfect in comparison to the other markets but there are certain inefficiencies which are inherent in the forging exchange market. The change in the global economic environment after the financial crisis in 2008 has caused considerable fluctuations in the market. This has been worsened with the already inherent speculative nature of the market. Therefore predicting the foreign exchange market is difficult and the investors should hedge against the risk of entering the market.

6. References

• “Reserve Bank of Australia – Home Page.” Reserve Bank of Australia – Home Page. N.p., n.d. Web. 6 May 2012. <http://www.rba.gov.au>.
• Ravi, Mohan. “Appreciation of Australia’s real exchange rate: causes and effects.” RBA ECONOMICS COMPETITION 2010 1.1 (2012): 1-15. Print.
• “Australian Dollar May Appreciate to 28-Year High on Coal, BNP Paribas Says – Bloomberg.” Bloomberg – Business, Financial & Economic News, Stock Quotes. N.p., n.d. Web. 6 May 2012. <http://www.bloomberg.com/news/2011-03-21/australian-dollar-may-appreciate-to-28-year-high-on-coal-bnp-paribas-says.html>.
• “Halo Financial Detailed Currency Report for AUD/GBP – Australian Dollar Research Report 27 April 2012.” Foreign exchange and currency rates from Halo Financial – The guiding light in foreign exchange. N.p., n.d. Web. 6 May 2012. <http://www.halofinancial.com/news/CurrencyReport.aspx?ReportID=3>.
• TradingEconomics.com, and RBA. ” Australia Inflation Rate.” TradingEconomics.com – Economic Data for 196 Countries. N.p., n.d. Web. 6 May 2012. http://www.tradingeconomics.com/australia/inflation-cpi
• IMF Data and Statistics.” IMF — International Monetary Fund Home Page. N.p., n.d. Web. 6 May 2012. <http://www.imf.org/external/data.htm
• “Monetary Authority of Singapore.” Monetary Authority of Singapore. N.p., n.d. Web. 6 May 2012. <http://www.mas.gov.sg/>.
• “Bank of Thailand.” www.bot.or.t. N.p., n.d. Web. 6 May 2012. <http://www.bot.or.th/english/Pages/B
• M. Nguyen, Nhat. “Purchasing Power Parity.” IFM 1.1 (2005): 1-9. Print.
• Madura, Jeff, and Oliver Schnusenberg. International financial management. 7th ed. Mason, Ohio: Thomson/South-Western, 2003. Print.
• “EC 247 Financial Instruments and Capital Markets.” /courses.essex.ac.uk/. N.p., n.d. Web. 5 May 2012. <http://courses.essex.ac.uk/ec/ec247/

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