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iLab: Exchange Rate Forecasting Exercise FINS3616: 2020 Term 3 Individualised Assignment for z5207220

Scenario You are part of a team evaluating foreign investment opportunities for your company. An important component to the valuation is forecasting future exchange rates. You are based in Sweden and the investment opportunity is in Switzerland. You decide to build a regression model that can be used to estimate future exchange rates using economic data. You expect that future exchange rate changes depend on a number of economic variables such as the two countries’ real GDP growth rates, the difference in inflation rates, and the difference in long-term interest rates between the two countries.

Instructions Follow the steps below for the analysis. Your base currency country is Sweden (Currency code: SEK) and your quoted currency country is Switzerland (Currency code: CHF). Use the estimated coefficients from your regression model to forecast the future exchange rates.

Data Collection Obtain market exchange rates for the period starting on the first quarter of 2002 through the fourth quarter of 2016. Use calendar quarters (i.e. March, June, September, December). You want to know the amount of CHF per SEK. 1. What is the average exchange rate over your sample period? (Hint: 0.14XX) Obtain quarterly data on the year-on-year percentage change in real GDP for the two countries in your pair. Using the year-on-year change allows you to measure GDP growth relative to the same quarter last year, which takes into account seasonal effects. 2. What is the average quarterly year-on-year percent change in real GDP for Sweden? (Hint: 2.2XX) 3. What is the average quarterly year-on-year percent change in real GDP for Switzerland? (Hint: 1.8XX) Obtain quarterly data on the year-on-year percent change in CPI for both countries. This is your measure of inflation. 4. What is the average quarterly inflation rate for Sweden? (Hint: 1.1XX) 1

5. What is the average quarterly inflation rate for Switzerland? (Hint: 0.36XX) Obtain quarterly data on long-term interest rates for both countries. 6. What is the average quarterly interest rate for Sweden (Hint: 2.9XX) 7. What is the average quarterly interest rate for Switzerland? (Hint: 1.7XX)

Qualitative Analysis Plot the market exchange rate over your sample period, taking a close look at the financial crisis period (20082009). 8. What was the effect of the crisis on the currency mark

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Exchange Rates Determinants You want to estimate how the future exchange rate will change in one quarter, in one year, and in three years. To do so, you will need to construct three additional columns in your spreadsheet. These will consist of the future exchange rate changes (written as ∆) for every quarter t, calculated as: St+1 −1 St St+4 −1 = St St+12 −1 = St

%∆S t1qtr = %∆S t1yr %∆S t3yr

You should have some empty rows in your dataset as you will not be able to calculate future exchange rate changes for the last (i.e. most recent) 1, 4, or 12 quarters in the sample. 9. What is the one quarter change in exchange rates from the first quarter of 2002 to the second quarter of 2002? 10. What is the one year change in exchange rates from the first quarter of 2002 to the first quarter of 2003? 11. What is the three year change in exchange rates from the first quarter of 2002 to the first quarter of 2005? Calculate the long-run interest rate differential (rhome − rf oreign ) between the countries in your assigned pair, as well as the inflation rate differential (ihome − if oreign ). Use Sweden as the home country and Switzerland as the foreign country. 12. What is the average interest rate differential? 13. What is the average inflation rate differential? Use the information you have collected to estimate a model for future exchange rate changes. You want to forecast exchange rate changes for different time horizons, so you will need three regressions which have the exchange rate change in one, four, or twelve quarters from now as the dependent (Y) variable. To identify which of the economic variables has the most predictive power, you include the difference in inflation rates, the difference in long-term interest rates, and each countries’ real GDP growth rates as independent (X) variables. The regressions will then estimate β coefficients that measure the average effect of each of these determinants on exchange rates:

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Change1qtr = β0 t + β1 · Interest Rate Differentialt + β2 · Inflation Differentialt + β3 · GDP Growth Homet + β4 · GDP Growth Foreignt + ǫt Changet1yr = β0 + β1 · Interest Rate Differentialt + β2 · Inflation Differentialt + β3 · GDP Growth Homet + β4 · GDP Growth Foreignt + ǫt Changet3yr = β0 + β1 · Interest Rate Differentialt + β2 · Inflation Differentialt + β3 · GDP Growth Homet + β4 · GDP Growth Foreignt + ǫt 14. Interpret the significance of the estimated coefficients. Which predictors are significant for each forecasting horizon? Do the signs of the coefficients make sense?

Forecasting Exchange Rates You now want to forecast the future exchange rate changes from 2016 Q4 to 2017 Q1, to 2017 Q4, and to 2019 Q4. Use the economic data (i.e. inflation rates, interest rates, real GDP growth) for 2016 Q4 and the regression coefficients from your estimations above to make the forecasts. 15. What is the expected change in exchange rates for 1 quarter? 16. What is the expected change in exchange rates for 1 year? 17. What is the expected change in exchange rates for 3 years?

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