ACFI3140 assignment 2020 Extension PDF

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ACFI3140 International Finance Assignment Due date: Monday Week 11 – 25th May 2020 23:59 AEST*** ***As part UoN’s COVID-19 response policy, an automatic two week extension to the above due date is available. Accordingly submissions made by 23.59AEST on the 8 June 2020 will not be subject to late lodgement penalties.

Introduction You will be asked to perform two major tasks in this assignment. The first task is to help you understand the Purchasing Power Parity implied exchange rate. The second task will provide you an opportunity to predict FX rates and use these quotes to test an exchange rate arbitrage opportunity.

IMPORTANT INFORMATION  The assignment must be attempted and completed individually  Upload the report through Turnitin  Use the university cover page when submitting reports  Any assignment submitted late will be penalised at a rate of 10% per day  The word limit is 2,000 words in total to be written using Microsoft MS word. The table of contents and reference section are not included in the word count.  To provide the supporting data for your report you will be required to record any calculation using Microsoft Excel. Use Excel formulas in your calculations so that the final answers can be justified and reconciled by reference to the formula in the cell. (Your Microsoft Excel spreadsheet needs to be prepared in a way that a colleague could open your spreadsheet and justify your calculations.)  The Excel work file for both tasks needs to be sent to [email protected].  Make and state any assumptions if the given information is insufficient to justify your answer.

ACFI3140 International Finance, Semester 1, 2020

University of Newcastle, NSW, Australia Page 1 of 6

Assignment Information The Economist publishes the Big Mac Index on a regular basis to provide an idea of the difference in purchasing power among different countries. In Australia CommSec provide an IPod index which shares similar ideas as the Big Mac Index. A more comprehensive index calculated by the OECD uses a basket of goods. The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by GDP.

1) Design a basket of goods You are required to design a basket of goods in two countries for the purpose of demonstrating your understanding of purchasing power parity. The two countries will be Australia and Canada. The basket of goods should contain ten different consumer goods. The ten different consumer goods are to be from two groups out of the 11 groups used by the Australian Bureau of Statistics (ABS) (See Inflation and its Measurement, 2017 for further details on the 11 groups). The products that you select can be any type of consumer goods but you are required to provide a reason of why you chose the specific products.

2) Exchange rate prediction You are required to setup a prediction model for remainder of the year. Your target is to make a prediction of the exchange rate between Australia and Canada. The prediction is to be for the expected exchange rate at the end of 2020. The prediction should be made assuming the current date is April 1st of 2020. This means that the exchange rate prediction is for a period of nine months ahead. You can use any information available to you when you attempt the assignment, but you must assume that you only have data available to you up to 31 March 2020. You should also take advantage of data available in FactSet such as historical FX price data, interest rate data and macroeconomic data. You are required to use a linear regression model with three independent variables that resembles the following equation: Change in exchange rates (CAD/AUD) = a 0 + a1(GDP growth rate differential (CAD-AUD)) + a2(expected inflation rate differential (CAD – AUD)) + a 3(Variable 3) Where: a0 = y intercept a1 = regression coefficient for GDP growth rate differential(CAD-AUD) a2 = regression coefficient for expected inflation rate differential (CAD – AUD) a3 = regression coefficient for Variable 3 Please note that FX quotes in this assignment are made on traditional market convention meaning that the base currency is quoted first, followed by the price currency. For example, CAD/AUD means the number of AUD per 1 CAD. In the regression model, the GDP growth rate differential, and expected inflation rate differential (CAD – AUD) for the two countries must be used as independent variables, while

ACFI3140 International Finance, Semester 1, 2020

University of Newcastle, NSW, Australia Page 2 of 6

you must select one other independent variable. You must justify why you selected the other independent variable. Data frequency for your regression model (EG: monthly, quarterly) is your choice, but ensure that you are consistent, and that all data required is available at your chosen frequency. To ensure meaningful regression results, you should use a historical data period that provides enough data points for a statistically robust analysis. For example, a quarterly model would need at least 10 years of historical data. The bid and ask rates for CAD/AUD are expected to change at the same rate as indicated by your regression model (i.e. the change in the exchange rates predicted for CAD/AUD are equal for the bid, ask and mid rates). At the start of April 2020 (1/Apr/2020), the spot rate of CAD/AUD (AUD per 1 CAD) was 1.1579 (bid) – 1.1585 (ask). You also checked the current FX quotes for the USD/CAD (CAD per 1 USD) and AUD/USD (USD per 1 AUD) currency pairs. The quotes were as below:

1 April 2020 Spot 1 Months Forward 2 Months Forward 3 Months Forward 6 Months Forward 9 Months Forward

USD/CAD Bid Ask 1.4178 1.4181 -3 -1 -9 -5 -13 -9 -26 -16 -35 -23

ACFI3140 International Finance, Semester 1, 2020

AUD/USD Bid Ask 0.6088 0.6090 1 1 1 2 1 2 0 2 -1 2

University of Newcastle, NSW, Australia Page 3 of 6

Required: Questions to answer Note: To provide the supporting data for your report you will be required to calculate the following in Microsoft Excel (Your Microsoft Excel spreadsheet needs to be prepared in a way that a colleague could open your spreadsheet and justify your calculations). That is, use Excel formulas in your calculations so that the final answers can be justified and reconciled by reference to the formula in the cell. Include your regression data and output in this file also.

1) Design of a basket of goods A. Interview two people and survey what type of expenditures they had in their household for the past three months to “maintain a standard of living” B. From the survey results select ten products you wish to include in your basket of goods. What are the products you picked and why? C. What is the price for each product in Australia and where did you obtain the price? D. What is the price for each product in Canada and where did you obtain the price? E. Evaluate the concept of ‘Law of One Price’ by observing the actual spot rate and comparing it with the implied PPP exchange rate. Discuss possible practical issues that could have impacted the implied PPP exchange rate.

2) Exchange rate prediction A. Explain how you collected the data for the prediction model and what issues you considered in selecting the data. B. What is your regression model (expressed as an equation) including the resulting coefficients. C. Provide a prediction for the expected CAD/AUD spot exchange rate at 31 December 2020. D. Does an arbitrage opportunity exist if you use the CAD/AUD rate you predicted in your regression model, and the forward FX quotes table above for USD/CAD and AUD/USD? If so, what would be the profit? Provide all calculations and identify whether your strategy is an uncovered or covered arbitrage strategy. Assume that you can freely borrow and invest in AUD, CAD, or USD using the central bank interest rates (cash rate for AU, target for the overnight rate for CA, the lower bound of the target range of the federal funds rate for US) E. Discuss ways you can test the performance of your model and ways to improve the performance of your model.

3) Report Structure Your report should be structured in a professional manner, free from grammatical errors and include a References list. Headings within your report could include: A. Part 1 – Design of a Basket of Goods 1. Survey Results 2. Products Included in Basket of Goods 3. Price of Products

ACFI3140 International Finance, Semester 1, 2020

University of Newcastle, NSW, Australia Page 4 of 6

4. Evaluation of ‘Law of One Price’ B. Part 2 – Exchange Rate Prediction 1. Collection of data 2. Regression Model 3. Prediction of CAD/AUD spot rate 4. Covered Arbitrage Opportunity 5. Testing Model Performance 6. Improving Model Performance

References Use American Psychological Association (APA) 6th Edition. You can find helpful examples of APA 6th ed. citation in pp 27–41 of the 2015 NBS Postgraduate Student Manual as well as at http://www.apastyle.org/index.aspx.

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University of Newcastle, NSW, Australia Page 5 of 6

Suggested Data Sources Historical spot exchange rates, interest rates, economic data can be found using your FactSet account: http://www.factset.com/

A list of products used to calculate the Consumer Price Index (CPI) is in the following link: http://www.ausstats.abs.gov.au/ausstats/subscriber.nsf/0/B1D241EA20B49DA0CA25822 5000D7F1F/$File/64400_2017.pdf Australian Bureau of Statistics (CPI explanation): http://www.abs.gov.au/ http://abs.gov.au/websitedbs/d3310114.nsf/home/Consumer+Price+Index+FAQs#Anchor13 Statistics Canada: http://www.statcan.gc.ca/start-debut-eng.html OECD database (economic projections): http://stats.oecd.org/Index.aspx?DatasetCode=KEI#

ACFI3140 International Finance, Semester 1, 2020

University of Newcastle, NSW, Australia Page 6 of 6...