Transcript Forecasting Method #1

Project #4:
Forecasting Exchange Rates
Group #3:
Kristin Olson
Chris Kline
Wiley McCreedy
6/30/09
The Spot Rate Starting Point
-For all forecast models used in our analysis our
common starting point is the USD/AUD spot
rate as follows:
On June 26th, 2009 the Australia Dollar was
trading with the following spot rate:
American Terms: .80531 USD/AUD
European Terms: 1.2418 AUD/USD
Forecasting Method #1:
Asset Choice Model
For this model we will incorporate three elements of the
Australia environment into an analysis to forecast the
exchange rate 6 and 12 months from now. These
elements include:
1. Interest Rate Differential (impacts)
2. Possibility (and impact) of Carry-Trade Strategy
3. Possibility (and impact) of Government
Intervention
We will attempt to quantify each of these elements in terms
of either an appreciation or depreciation of the AUD for
the time periods specified.
Forecasting Method #1:
Interest Rate Differential Impact
AUD Exchange Rate v. Interest Rate Differential
1.2
6.00%
5.25%
$.95808
$.87124
4%
0.8
5.00%
4.00%
5/3/09
3/3/09
1/3/09
11/3/08
9/3/08
7/3/08
5/3/08
0.00%
3/3/08
0
1/3/08
1.00%
11/3/07
0.2
9/3/07
2.00%
7/3/07
0.4
5/3/07
3.00%
3/3/07
0.6
1/3/07
Exchange Rate (AUD/USD)
1
Exchange Rate
Differential
If the US Federal
Reserve increases
interest rates, which it
may have to in order to
control liquidity from
the stimulus, this may
impact the AUD
exchange rate with
upward pressure as the
differential grows
considering Australia is
aiming to keep its cash
rate stagnant.
Date
As seen in the chart above an increase of 1.25% in the differential
increased the USD/AUD exchange rate by 9.97%. If this follows and the
Fed increase rates by .25% an expected increase in the exchange rate
would be 1.99%. This will be included in our asset choice forecast.
Forecasting Method #1:
Carry Trade Impact
USD/AUD Exchange Rate
1
Nov 07: $.93697
0.9
0.8
0.6
March 06: $.70573
0.5
0.4
0.3
0.2
0.1
Dates (2005-2007)
11/4/07
9/4/07
7/4/07
5/4/07
3/4/07
1/4/07
11/4/06
9/4/06
7/4/06
5/4/06
3/4/06
1/4/06
11/4/05
9/4/05
7/4/05
5/4/05
3/4/05
0
1/4/05
USD/AUD
0.7
With talks of a potential
revival of carry trade strategy
as spreads in interest rates
grow post the global
recession, it is important to
quantify a potential impact
such a strategy would have
on the AUD. The most
recent example is the carry
trades between the JPY and
AUD between 2005 and
2008. The build up (thus
greater demand for AUD) of
this is seen in the chart.
As a result of the carry trade strategy and its impact on the demand for the
AUD we saw from early 2006 to late 2007 an increase of 33% in appreciation
for the USD/AUD. If this holds and a strategy exists in the next 12 months we
will see similar impacts that are accounted for in our asset choice model.
Forecasting Method #1:
Government Intervention Impact
-It is clear that the leadership of the Australian government and
monetary policy holds strong on the strength of their export sector and
its revival as the global recession ends. If they do in fact see this as
pivotal to their comeback, they will need to keep the exchange rate low or
risk an adverse effect on their exporting capabilities.
-According to the Reserve Bank of Australia they currently carry 6.286
billion AUD in their reserve fund. They could use this as a form of
direct intervention to increase the supply of AUD in the forex markets
and thereby place downward pressure on the exchange rates.
-The impact of this is measured by comparing it to New Zealand
intervention during the summer of 2007. They sold 120 million kiwi and
for a temporary period decreased the value by 1.33%. Because of its large
reserves a potential impact double this by Australia will be included in
our asset choice model.
Forecasting Method #1:
Summation of Impacts
As discussed we expect that three elements (interest rate differential, carry trade
strategy and government intervention) are plausible impacts on the exchange rate in
the next 12 months. We quantify these elements in the following fashion:
Element
Possibilty %
Absolute impact
Weighted impact
Interest Rate Differential
100%
1.99% appreciation
1.99% appreciation
Carry Trade
25%
33% appreciation
8.25% appreciation
Government Intervention
80%
2.66% depreciation
2.128% depreciation
TOTALS
N/A
N/A
8.112% appreciation
Therefore, the asset choice model indicates:
1 year change in AUD = $.80531 x .08112 = .065327
1 year spot AUD = $.80531+.065327 = $.87064
6 month spot AUD = $.80531 + (.065327/2) =$.83797
Forecasting Method #1:
Purchasing Power Parity Model
-The PPP model assumes that exchange rates will change to offset
relative prices levels between countries and that the change will
correspond equally with the inflation differential between the two
countries:
United States expected inflation (12 month): 1.94%
Australia expected inflation (12 month):
2.25%
Differential:
0.31%
Given this, the expected depreciation of the AUD per the PPP is as
follows (6 and 12 month forecast):
PPP Spot USD/AUD Forecast
1 year change in AUD: $ .80531 x .0031 = 0.002496.
1 year spot AUD: $.80531 - .002496 = $.80281
6 month AUD: $.80531– (0.002496/2) = $.80531– 0.001248 = $.8041
Forecasting Method #1:
International Fisher Effect
The IFE model assumes exchange rates will change in proportion to
relative differences in longer term interest rates as follows:
Assume:
Current USD/AUD spot rate:
$.80531
Current 1 year Australian Government Bond rate:
3.41%
Current 1 year U.S. Government Bond rate:
0.43%
Differential:
2.98%
IFE Spot USD/AUD Forecast as follows:
1 year change in AUD = $.80531 x 0.0298 = 0.023998
1 year spot AUD = $.80531 - .023998 = $.78131
6 month spot AUD=$.80531 - (.023998/2) = .80531-.011999= $.79331
Forecasting MethodS #1-3:
SUMMARY OF FORECASTS
By testing the three theories prior (asset choice, purchasing power parity
and international fisher effect) we come to the following forecast
conclusions for the AUD in the next 6 and 12 month periods:
Model
Current
Spot
USD/AUD
6 month
spot
USD/AUD
% change
12 month
spot
USD/AUD
% change
Asset Choice
Model
$.80531
$.87064
8.1124%
$.83797
4.056%
Purchasing
Power Parity
$.80531
$.8041
-0.1503%
$.80281
-1.49%
International
Fisher Effect
$.80531
$.79331
-1.49%
$.78131
-2.98%
Forecasting Methods:
Our Recommendation
-When considering which model to recommend as our assurance to
MNC’s in the global arena it is important to remember that our time
periods (6 and 12 months) are in the longer middle term.
-Given this and the fact that both the IFE and PPP have shown that
they are unsuccessful in accounting for short term unexpected
deviations, we recommend our asset choice model and the
implications it has for the AUD exchange rate over the next 12
months.
-The asset choice model is successful in considering unexpected
deviations at a time when there is no clear precedent for expectation.
The revival from the global recession will be a tumultuous period and
sticking to possibly outdated and simplistic models may deem adverse
for any MNC operating in the global sphere.
Advisement to MNC #1
Our first client, MNC #1, is facing two significant short positions with
the AUD in 6 and 12 months, meaning they will need to buy AUD at
these time periods.
Our recommendation is the following:
-The MNC hedge this position given the uncertainty of
the global economy at this time.
-The MNC do so with an options call contract.
-This options contract will give them the flexibility to:
a) Capitalize off a depreciation of the currency
and receive more AUD for less USD
b) Protect their firm from a significant
appreciation of the AUD as the asset choice
model indicates.
Advisement to MNC #2
Our next client, MNC #2, is facing two significant long positions with
AUD in the next 6 and 12 months meaning they will be looking to sell
AUD at those specific time intervals.
Our recommendation is the following:
-The MNC hedge this position given the uncertainty of
the global economy at this time.
-The MNC do so with an options put contract.
-This options contract will give them the flexibility to:
a) Capitalize off a appreciation of the currency
and receive more USD for less AUD.
b) Protect their firm from a significant
depreciation of the AUD given any factors the asset
choice model does not anticipate.
Project #4 Resources
Data and charts on exchange rates:
http://fx.sauder.ubc.ca
Data on interest and inflation rates:
www.Bloomberg.com (various articles in news section)
Information on Australia reserves, etc.
Reserve Bank of Australia
http://www.rba.gov.au/
Carry Trade Strategy Information:
-case study by Professor Palmer on New Zealand intervention
in forex markets