Exchange Rate Behavior

November 6th, 2011 International Financial Management Assignment # 2

Exchange Rate Behavior

As an employee of the foreign exchange department for a large company, you have been given the following information: Beginning of Year Spot rate of = $1.596 Spot rate of Australian dollar (A$) = $.70 Cross exchange rate: 1 =A$2.28 One-Year forward rate of A$ = $.71 One-Year forward rate of = $1.58004 One- Year U.S. interest rate = 8.00% One-Year British interest rate = 9.09% One-Year Australian interest rate = 7.00% Determine whether triangular arbitrage is feasible and, if so, how it should be conducted to make a profit.

The triangular arbitrage is not feasible because the cross exchange rate between and A$ is properly quoted and rate is not equal to the markets implicit cross exchange rate. If the market cross exchange rate quoted by a bank is equal to the implicit cross exchange rate or implied from the exchange rates of other currencies, then a no arbitrage condition is sustained. Proper Cross exchange rate = Spot rate of $1.596/Spot rate of A$ (.7) = 2.28

Exchange Rate Behavior

Using the information in question 1, determine whether covered interest arbitrage is feasible and, if so, how it should be conducted to make a profit. Covered interest arbitrage is only feasible when interest rate parity does not exist.

Currency

Forward Premium

Actual forward Premium

Pound ()

P= (1 + ih)/(1 + if) -1

P = F S/S

= (1.08)/(1.0909) -1

= $1.58004- $1.596/ $1.596

= -.01

= -.01

Australian Dollar (A$)

P = (1 + ih)/(1 +ir)

P = F S/S = (.71 -$.70)/ $.70 = .01428

= (1.08)/(1.07) -1 = .0093

Interest rate parity exists for the British pound. However, interest rate parity does not exist for the Australian Dollar. The premium is higher than it should be, the United States investors could benefit from the discrepancy by using covered interest arbitrage. The forward premium would receive when selling the Australian Dollar at the end the year more and offsets the interest rate

Exchange Rate Behavior

and the United States will receive 1% less interest on the Australian investment, they receive 1.428% more when selling Australian dollar will initially pay. In the real exchange rate reverts to some mean level over time, this suggests that it is constant in the long run, and any deviations from the mean are temporary. Conversely, if the real exchange rates move randomly without any predictable pattern, it does not revert to some mean level and therefore cannot be viewed as constant in the long run. (2010 Madura pg. 242). Based on the information in question 1 for the beginning of the year, use the international Fisher effect (IFE) theory to forecast the annual percentage change in the British pounds value over the year. The IFE (International Fisher Effect) suggests that given two currencies, the currency with a higher interest rate reflects higher expected inflation, which will place downward pressure on the value of that currency. The IFE is the application of the Fisher effect to two countries in order to derive the expected change in the exchange rate. It suggests that nominal interest rates of two countries differ because of the difference in expected inflation between the two countries (2010 Madura, pg. 243). The currency adjustment will offset the differential in interest rates.

Ef = (1 + ih)/(1 + ir) -1 = (1 + .08)/(1 + .0909) -1 = -.01 which is -1% Pound is expected to depreciate by 1 percent over the year. There are 3 scenarios of IFE. First resulting in Local currency depreciated by level of inflation, which is shown above. Second is

Exchange Rate Behavior

Local currency value appreciated by level of inflation differential, and finally local currency value is not affected by inflation. Assume that at the beginning of the year, the pounds value is in equilibrium. Assume that over that year the British inflation rate is 6% while the U.S. inflation rate is 4%. Assume that any change in the pounds value due to the inflation differential has occurred by the end of the year. Using this information and the information provided in question 1; determine how the pounds value changed over the year. If PPP the pound changes by the following formula

Eq = (1 +1h)/(1 +1f) -1

= 1.04/1.06 1 = 0.189 or 1.89% The pound changed by 1.89% of the year. Assume that the pounds depreciation over the year was attributed directly to central bank intervention. Explain the type of direct intervention that would place downward pressure on the value of the pound. The direct intervention of the foreign exchange market by the central banks used pounds to buy U.S. dollars place downward pressure on the pounds value. But central banks may purposely try to raise interest rates to attract funds or strengthen the value of their own currencies. A lot of

Exchange Rate Behavior

MNC invest cash in money market securities to develop countries with a slightly higher interest rate.

Exchange Rate Behavior

References

Madura, J. (2010). International financial management: 2010 custom edition (10th Ed.). Mason, OH: South-Western, Cengage Learning.