International Finance Assignment: Questions and Answers
Task: The assignment accounts for 100% of the marks for this module.
This assignment asks you to complete the computational questions in section A and write two essay questions in Section B
A1: You are considering uncovered interest arbitrage between the pound (GBP) and the US dollar (USD). Data available to you is as follows:-
5 million GBP
Spot exchange rate
1.3000 USD per GBP
Spot exchange rate one year ago
1.2350 USD per GBP
USD 3-month interest rate
2.51% per annum
GBP 3-month interest rate
0.75% per annum
a) Calculate the profit that would be made if the exchange rate remains at its current level in three months’ time.
b) How would your answer differ if GBP continues to strengthen at the same rate as it has done over the previous year?
A2 A company based in Italy has sold equipment to a customer in Brazil for R$ 12 million (Brazilian Reals, BRL). Payment is due in three months’ time. The following data is available:-
3 month forward rate
BRL borrowing interest rate
6.5% per annum
BRL investment interest rate
4.25% per annum
Strike price for a 3 month put option on BRL
Premium for this PUT option on BRL
The company’s cost of capital
5% per annum
Evaluate ways in which the company can manage its risk. Which of these alternatives do you recommend?
By critically reviewing the relevant theoretical and empirical literature, discuss the arguments for and against central banks allowing a currency’s value to fall without intervention. You must, additionally, illustrate your arguments with case studies from any part of the period 1920 to 2020.
With reference to relevant literature and theory, critically discuss to what extent exchange rates can be predicted.
The amount which will be invested in USD is 5 million GBP, i.e. equivalent to
500000*1.3 = 6500000USD
The amount will be invested at the interest rate of 2.51% per annum for three months. The amount of interest after three months is
The total amount receivable including interest and principal is
= 6500000 USD+ 40787.5 USD
To invest 5 million GBP amount is required to be taken in the form of loan and paid at an interest of .75% per annum for three months. The amount to be paid after three months is equivalent to
= 5000000 + (5000000*.75*3/12)
Now the amount received after investing 6500000USD for three months, i.e. 6540787.5 USD would be sold back and converted in GBP
= 6540787.5 /1.3
The amount of profit is 50313375 GBP - 5009375GBP
In case GBP continues to strengthen at a similar rate as in the previous year; the profit will be as follows:
The rate at which the spot exchange rate has been enhanced is as follows:
Present rate – Previous year rate/ Present rate *100
= 1.3-1.235/1.3 *100
The exchange rate has been increased by 50%; thus current exchange rate would be increased by similar percentage 1.3*.5, i.e. .65
The new rate would be 1.3+.65 = 1.95
Now a similar amount of 5000000GBP will be invested after converting in USD. The amount to be invested for three months is
= 5000000 *1.95 = 9750000 USD.
The specified amount will be invested for three months at an interest rate of 2.51%.
The total amount of received on investment after three months is
= 9750000 USD +9750000USD *2.51%*3/12
= 9750000USD + 611811.25 USD
= 10361811.25 USD
Previously, 5000000GBP has been taken in form of loan at the interest rate of .75% for three months. The amount to be paid is equivalent to
= 5000000GBP + 5000000GBP*.75*3/12
= 5000000GBP + 9375 GBP
= 5009375 GBP
At the end of three months, 10361811.25 USD will be received, and it will be converted in GBP, i.e. = 10361811.25/1.95
= 5313749.35 GBP
Profit attained at the end of three months
= amount received – Amount to be paid
= 5313749.35 GBP – 5009375 GBP
= 304374.35 GBP
The company does have the option to make payment after three months at future spot price and not to hedge in the following manner:
Future price = Current Price * [1+ Risk free rate* - Dividend]
Current price = 4.5385 BRL/EUR
Dividend = 0
Risk free rate = 4.25*90/365 i.e. 1.04%
Future price = 4.5385 *1.0104
= 4.5857 BRL/EUR
Rate of 1BRL = 1/4.5857 EUR
= 0.218069 EURO
The amount to be paid is
= 120000000* 0.218069
= 2616831 EUR
The company does have another option to reduce the risk by adopting the option of purchasing a forward contract at the rate of 4.6668 BRL/EUR for three months. In the specified option,the company would be required to make payment of 5% of the cost of capital for holding the money required for reducing the risk.
The amount to be paid by the company if opted for the forward contract is
= 12000000 /4.6668
= 2571355 EURO
Decision: In case the organization does not enter into the forward contract for hedge their position, then company have to deal at higher future spot price. Thus option two, i.e. hedging risk through forwarding contract should be accepted by the company.
Currency deprecation refers to a reduction in value of the currency underfloating exchange regime. The reason behind the same could be economic fundamentals; differences are interest rate, political instability. The nation which does have a weak economic fundamental, i.e. current account deficit and high rate inflation does deal with issues relating to the decrease in the rate of a currency (Chen and Lee, 2019). However, significant currency depreciation might negatively affect foreign investors and enforce them to pull portfolio investment out of their country and resulting in downward pressure on the currency. The intervention made by the central bank can be applied to boost as well as decrease value of the currency. The most common reason for enhancing or decreasing rate of a currency is having an impact on productivity and exports of a specific nation. Even though adequate criticism does exist regarding authorities, which use market interventions excessively to amplify their currency value (Perera, Buckley and Long, 2018).
Arguments for allowing central bank for intervening while a decrease in value of the currency
It is a fact that central bank or policymakers mightinterfere in the foreign exchange market for various economic objectives, i.e. putting control over inflation in the nation, maintenance of competitiveness as well as monetary steadiness. Thus, it can be stated that the central bank allows a decrease in any currency value without intervention to the extent the downfall in currency does not endure extreme and unnecessary upward and downward financial pressure. In general high volatility relating to trading by speculators and market player is controlled by the central bank through Forex market intervention to stabilise the situation.
The rate of exchange generated by the market might be not reliable as compared to given economic aspects. The reason behind same might be the application of the wrong model and incorrect perceptions about the future (Della Posta, 2018). The fact can produce incorrect exchange rate does not validate the interfere through central bank as it is essential for authorities to intervene to smooth the economic adjustment process and mitigate the cost of exchange rate overextending. The Dornbusch overshooting model represents that financial restriction could result in appreciation of short-run real exchange rate ; on the contrary expansionary monetary policy could assists to real depletion in currency. The specified movements in the real exchange rate lead to over-and undervaluation relating to purchasing power parity which exertsan impact on the real economy (Perera, Buckley and Long, 2018). It is necessary to refer major deviation from PPP as misalignments do exist in the exchange rate.
For instance, in 2015 Swiss National Bank decision was taken relating to abandon Swiss franc’s peg to euro which assists to disputes in the exchange market for short term period and had a diminishing impact on the economy of Swiss (Alcidi, 2015). Economist assessed that Switzerland was dignified to enter a sustained period of stagnation a la Japan. However, a specified intervention cannot be justified in specified conditions, i.e. in the case ofthe market provides the wrong rate, which leads to the imposition of significant economic cost. Thus recently quantitative easing program was assessed as a veiled effort to decline euro to enhance the euro zone’s competitiveness.
Another case which has been witnessed regarding intervening of the central bank in response to the monetary disasters through embarking three rounds of Quantitative Easing by Federal Reserve, which sent bond yield to record law in the year 2008. The U.S. dollar index declined in excess of 10% in six weeks after implementation of quantitative easing (Agostini, 2016). Again in the year, 2010,the same result was assessed when USD depreciated, the greenback affected all-time lows in contrary tothe Japanese yen, Australian Dollar and Canadian Dollar.
Arguments against empowering central bank for intervening while a decrease in value of the currency Foreign exchange intervention can be specified as a monetary tool applied by the central bank. However, the success of interfere based on the manner in which central bank sterilises effect of its intervention along with macroeconomic policies which are established by the government. The arguments which are available against the intervention of central government are major regarding the difficulties dealt regarding the timing and quantum of intervention (Pelizzon and et al. 2016). It does require detailed research to assess economic trouble faced by the country and market conditions which change continuously. The central bank might assess that the specific currency has become out of sync with the nation’s economy and possessing negative impact on it. For instance, countries which are heavily dependent on exports might assess that their currencies are stronger in comparison to other countries to purchase the goods they purchase. Thus, in specified situation intervention could assist in keeping the currency in accordance with currencies of the country which export their products. Another risk attached with central bank intervention is that it might undermine central bank creditability in case they do not succeed to main stability.
From the period September 2011 to January 2015, minimum exchange rate has been determined by theSwiss National Bank between Swiss Franc and Euro (Alcidi et al. 2015). The step resulted in strengthening Swiss Franc afar a level of acceptance for importer of Europe in relation to Swiss products. The strategy was effective for a period of 3.5 years, however afterwards SNB decided that Swiss Franc would float freely without warning that they released minimum exchange rate. It negatively affected business to some business, but in general,the economy has been unfazed by the intervention.
In the year 2013, the currencies of India and Indonesia dealt in sharp mannerlesser as Federal Reserve was poised to wind down significant purchases of bonds (Spicer and Lange, 2013). Even developed countries do deal with extreme volatility. As in June 2016, British Pound decreases to 8% over U.S. dollar after the U.K voted to lead European Union referred to Brexit (Pound plunges after leave note, 2016).
Further, in year2015 and 2016, the battle of words was assessed between the U.S. and China regarding currency value of each other. In August 2015, the People’s Bank of China reduced yuan, their currency by 1.9% against USD. The reason specified behind the same was preventing further slide in exports (China Rattles market with Yuan Devaluation, 2015). However, in the 2016 election campaign, Donald Trump republican nominee stated those Chinese officials were purposely decreasing the value to attain unfair advantages relating to trade. The same resulted in the trade agreement among the two significant economies of the world.
Discussion and Analysis
It can be started from the above assessment that central bank intervention is majorly related to stabilising the currency. The fact cannot be denied that the destabilising effect comes from the market as well as non-market forces. In order to stabilise currency short, as well as long interventions, are made by the central bank. When central bank enhances money supply through various resources, it does assess the mitigate unintended effect such as runaway inflation. It is a fact that the success of intervention of the central bank depends on the effect of intervention and macro-economies policies determined by the government. Involvement in the foreign exchange market could be specified as an important feature of the conduct of economic policy. As the central bank might buy or sell foreign exchange for different reasons (Uz Akdogan,2020). They are empowered to promote orderly market conditions, attempt to mitigate trend like appreciation and depreciation in the price of the currency. Whatever, the intentions of the central bank are, the consequences of their action will depend on a domestic asset which has been construed and the reaction of private institutions and foreign central bank to these purchases. There does exist, ample witness that intervening is done to dampen exchange rate volatility, slow down exchange rate adjustments (Fanelli. and Straub., 2017). Following assertions of Farhi and Wering, optimal capital controls are used to lean against the wind after interest rate fluctuates significantly while they are not applied against endowment shocks. In baseline mode, analogous results have been assessed for foreign exchange interventions, but it has been analysed that additional cost relating to foreign exchange interventions are crucial optimal policy. Overall, it would be appropriate to state that central bank intervention is made due to the sudden decline in the value of the currency. In order to make an adequate response to decreasing currency, the initial step is to enhance short term interest under their control (Gevorkyan and Canuto, 2016). Enhancement in interest rate results in stabilising the domestic currency, the resulting output cost could be substantial. The central bank does not limit to defend domestic currency in turbulence scenario. It depends on the market situation, which has resulted in a decrease in currency rate. The intervention is made to the extent possible of a further decrease in currency is mitigate.
A decline in currency rate might lead to major financial difficulties for the nation having high budget deficits. Financing the deficit might result in extreme delay and will jeopardise the economic growth of the country (Selgin, Be?dard and Dowd, 2017). Thus, to maintain the currency’s value, it is necessary to enhance rate of interest. It can be concluded that intervention by the central bank is essential to stabilise the currency rate as well as to deal with the financial crunch by every nation in an adequate manner. Lastly, it can be stated that the central bank must take adequate measures without emphasising on the value of the currency. Otherwise, forex intervention could negatively affect the nation’s economy.
The exchange rate is referred to as the value of the currency of one nationconcerning the currency of other nation. Investors and economists usually tend to predict the exchange rate in the future period by which they could depend on the estimation to obtain monetary value. Several distinct methods could be implemented to determine the rate of exchange of the currency in the future period (Wilcoxson Follett and Severe 2020).
Although, in the case of estimation of the future exchange rates, almost all of these machinesare full of comprises with complexities and none of these methods could be eligible to provide 100% surety in obtaining the precise value of future exchange rate. Forecasting of the rate of exchange is generated by the calculation of value as well as other currencies of a foreign nation for a particular period (Narayan and et al. 2020). There are several theories, by which an investor could predict the future exchange rate, but all of them have possessed some limitations.
Forecasting of exchange rates: Approaches
Usually, there are two approaches for prediction of future exchange rates, such as –
Fundamental approaches: It is considered a forecasting method tool, which utilised basic data link to a nation. In this aspect, some of the elementary information which is used by the investor for prediction of future exchange rates consists of Gross Domestic Product Rate, Rates of inflation, productivity, rate of unemployment, the balance of trade, and some other aspects (Samuel and et al. 2016). The principle on which this approach is founded is that the true and real value of a currency would be ultimately recognised at some point in time. It could be noted that this technique is appropriate for the investors who want investment for a long term period of time.
Technical approaches: In this technique, the future exchange rate is determined onthe basis of sentiments of the investors. Usually, the investor estimates with the help of chart patterns (Grossmann, Paul, and Simpson, 2017). Along with this, based on positioning survey, trade rules concerning moving-average trend seeking, and customer flow data of the Forex dealers, are also applied in the cited approach.
Forecasting of exchange rates: Models
Some of the important methods for forecasting of the future exchange rates are explained as below –
Purchasing Power Parity Model: This predicting model is founded onthe basis ofLaw of One Price. As per this model, there should be identical prices of similar goods in the distinct nations. Therefore, a unit currency in the home nation should possess the similar power of purchasing in the foreign nation (Crespo Cuaresma, Fortin, and Hlouskova, 2018). For instance, it has been argued by the cited law that, the prices of chalk in Australia would have the similar price as the chalk of identical dimension in US, considering the rates of exchange, and exclusion of transaction as well as the cost associated with shipping. To this note, there is not any opportunity of arbitrage is available to the investor to purchase at low prices in the one nation and sell at higher prices to another nation. Based on the standard, it has been predicted that the rate of exchange would be adjusted by equalizing the prices changes occurring because of inflation.
For instance, it has been assumed that prices of the US are estimated to be increased by 4% in the subsequent year, and prices of Australia would be raised by 2%. Then in such situation, the differential in the inflation among America and Australia is –
0.04-0.02 = 2%
As per this, prices in the U.S. would increase in a fast manner in comparison to prices of Australia. Thus, as per this approach,the U.S. dollar would reduce by around 2% to stimulate the prices in these two nations. Therefore, in the case was 0.90 US dollar per Australian Dollar, then the future exchange rate prices based on PPP –
(1 + 0.02) × (US $0.90 per AUS $1) = US $0.918 per AUS $1
=.918 US dollar per Australian Dollar
Relative economic strength model: As per this model, the future rate of exchange is determined by the directions of the rate of exchangebased onthe power of economic advance in distinct countries. In other words, it could be said that relative economic power considers at the strength of growth in economy in the distinct nationalities to determine the appreciation and depreciation of exchange rates (Fan, Li, and Zhao, 2018). The primary reason behind such a model is that strength in the growth in the economy would fascinate more investment from the outside investors. To buy these investments in a specific nation, the investor would purchase the currency of the country, accelerating demand and prices of the currency of that specific nation (Galeshchuk, and Mukherjee, 2017).
Apart from this, another element carrying investors to the country is its rate of interest. In this aspect, the high rate of interest would attract more investors, and there is an increment in the demand of that currency, which would assist towards appreciation in the currency. In contrary to this, a lower rate of interest would do in a converse manner, and the investor would not want to invest in a specific country (Chua, 2018). The investor would even borrow that currency of low-priced of the country to finance other investments. This was the case scenario when the rate of interest of Japanese Yen was meager. This is usually calledthe carry-trade strategy.
In this aspect, the relative economic strength model does not assist in prediction of the future exchange rate in a precise manner, similar to the PPP approach. It just shows the direction of currency, whether it would appreciate or depreciate in the future time. It is considered as a more general assessment of currency rates of the country. The cited method looks to the growth in the economy of the provided country (Melvin, and Norrbin, 2017). If the economy is strong, then in such case an investor could builda good prediction that this growth would appeal investors. To purchase the investment, they are required to buy the currency of the nation. This would lead towards bumping up in the rate of currency because of the increase in demand. The high rate of interest is considered a good indication for the investor, also leading rise in the currency (Lin, and Lee, 2016).
Econometric Model: This model is one of the complicated methods as they are founded on economic theory. Usually, in this, an investor picks an economic element that creates an impact on the currency, and on the basis of this model is created. It is the technique, which considers all relevant elements that create an impact of certain currency for forecasting of the future foreign exchange rate (Lothian, 2016). It links all these elements to estimate the rate of exchange. The elements are usually from economic theory, but at the time of requirement, any variable could be added. For instance, say, a predictor for a company of Canada has investigated elements, he reflects would create an effect on the exchange rate between USD/CAD. From research and investigation, it has been found by him that the most significant elements are, differential in interest rates, differences in the growth rates of GDP, the income growth rates differences. It has been ascertained that the cited model could determine the future exchange rate is as follows –
USD/CAD (1 year) = z + a (INT) + b (GDP) + c (IGR)
In the above case,
INT denotes interest rate differential
GDP denotes growth rate differentials
IGR denotes income rate differentials.
Further, the coefficient applied, such as a, b, and c would create an impact on the rate of exchange and would ascertain its direction, whether it is positive or negative.
Time Series model: This model is technical in a whole manner, and it does not consist of any economic theory. In this aspect, the famous time series model is called as autoregressive moving average (ARMA) process. The primary reason behind, historical behaviour and pattern of the prices could create an impact on the future prices pattern as well as behaviour. The data and information applied in this method is only the time series of data to apply chosen parameter to build the workable model (Wang and Liu, 2018).
It has been concluded that forecasting about the future exchange rate is very difficult and this is the reason several investors, as well as companies, just like to hedge the risk associated with movement in the foreign exchange rates. Still, some investors believe in predicting exchange rates and try to find out the elements that create an impact on the movement in the currency rates. For all them, all the above approaches and model that has been described are considered as a good point to initiate with. ?
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