FNCE90016: International Financial Management Assignment.

Exchange Rate Movements You are an analyst working for an Australian investment company. Your company has signiﬁcant investments in the United States that are exposed to movements in the AUD / USD exchange rate. You have been tasked with testing the validity of two models proposed to explain exchange rate movements over time: Uncovered Interest Rate Parity (UIRP) and Relative Purchasing Power Parity (PPP). FNCE90016: International Financial Management Assignment.You have gathered quarterly data on consumer price indices, interest rates and exchange rates for Australia and the United States from the period December 1989 to December 2019 inclusive.

Details of the data sources are below:
The consumer price index for Australia is the RBA’s “Consumer price index; All groups” series, obtained from the ﬁle “g01hist” on the RBA Statistics webpage.
The Australian interest rate series is the annualised interest rate on Australian Bank Accepted Bills / Negotiated Certiﬁcates of Deposits with three month maturities, expressed as a decimal, obtained from the ﬁle “f01hist” on the RBA Statistics webpage.

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The consumer price index for the USA is the “All Urban Consumers: All Items in U.S. City Average, Index” (series: “CPIAUCSL”) from the Federal Reserve Economic Data webpage, maintained by the Federal Reserve Bank of St Louis.
The US interest rate series is the annualised interest rate on 90 day US certiﬁcates of deposits (series “IR3TCD01USM156N”), expressed as a decimal, from the Federal Reserve Economic Data webpage, maintained by the Federal Reserve Bank of St Louis.
The spot AUD/USD exchange rate expressed as USD per AUD — S(USD/AUD) — is obtained from ﬁles “f11hist” and “f11hist-1969-2009” on the RBA Statistics webpage
These data have been downloaded and merged. The cleaned data for this assignment are provided to you in excel format via the LMS Assignment page (ﬁlename: Assignment Data.xlsx).FNCE90016: International Financial Management Assignment.
1. For variables (a)-(c) below, using data from March 1990 to December 2019, neatly report the following summary statistics in one table: the mean, the median, the standard deviation, the skewness and the min and max (pay attention to signiﬁcant ﬁgures).
(a) The simple diﬀerence in the quarter-on-quarter inﬂation rates between the US and Australia: πUS t −πAus t (we will refer to this as the inﬂation diﬀerential). Note you must ﬁrst calculate the quarter-on-quarter inﬂation rate from the two CPI series. (b) The simple diﬀerence in three month interest rates in the US and Australia: iUS t −iAus t (we will refer to this as the interest rate diﬀerential).
(c) The quarterly return in the FX spot rate S(USD/AUD).
Which currency (AUD or USD) would carry trade investors usually invest in and why? How does the historical skewness in the S(USD/AUD) return aﬀect this carry trade risk? (3 marks)
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2. Carefully plot the spot exchange rate S(USD/AUD), the inﬂation diﬀerential and the interest rate diﬀerential data series over the period March 1990 to December 2019. Make sure that you present the plot(s) in a well-scaled and informative manner. (2 marks)
3. You have been asked to provide econometric evidence regarding UIRP and PPP. You run two simple linear regressions to formally test whether inﬂation diﬀerentials and interest rate diﬀerentials explain returns in the Australian dollar vs. the US dollar.
(a) Using observations where t covers March 1990 to December 2019 inclusive, run a regression where the dependent variable is the quarterly S(USD/AUD) return in time t, st, and the independent variable is the inﬂation diﬀerential, ∆πt = πUS t −πAus t , in time t: st = απ + βπ∆πt + ut (1)
where απ is the intercept and ut is an error term. Neatly report the regression output in a table and comment on the results. Assuming that inﬂation rates in both countries are relatively low and that realized inﬂation at time t is a good proxy for time t inﬂation expectations formed at time t−1, what does purchasing power parity predict that the parameter βπ should be?1 Perform a hypothesis of test of this prediction and interpret the result with respect to the PPP prediction.FNCE90016: International Financial Management Assignment.
(b) Using observations where t covers March 1990 to December 2019 inclusive, run a regression where the dependent variable is again the quarterly S(USD/AUD) return, st, but now the independent variable is the interest rate diﬀerential in the previous period, ∆it−1 = iUS t−1 −iAus t−1 : st = αi + βi∆it−1 + εt. (2)
Neatly report the regression output in a table and comment on the results. What does uncovered interest rate parity predict that the parameter βi should be (assuming interest rates in both countries are relatively low)? Perform this hypothesis test and interpret the result with respect to the UIRP prediction.
(8 marks)
4. In one paragraph, summarize your ﬁndings from part 3 regarding UIRP and PPP. (2 marks)
1The assumption that realized inﬂation is a good proxy for inﬂation expectations can be justiﬁed by an assumption that agents have perfect foresight regarding inﬂation.
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Hedging Alternatives Lunar Capital Partners (LCP) is an Australian Private Equity ﬁrm. They invest in assets in both Australia and New Zealand. The fund predominantly raises capital in Australian dollars and its distributions are denominated in Australian dollars. LCP are considering purchasing a New Zealand auto-repair chain, AutoNZ, for a total cost of NZD50m. If the deal took place, it would require LCP to pay this amount in one month from today. The General Partners of LCP are concerned about the currency risk of this potential deal. They have asked you to discuss possible hedging alternatives with them. Speciﬁcally, they wish to consider the following alternatives:
Entering into an FX forward contract.
Purchasing an option with strike price equal to 0.9250.
They are provided with the following quotations in the FX spot market, FX forward market, Australian and New Zealand Money Markets (annualised 1 month interest rates in both countries) and the FX option markets:
Table 1: Market Prices
FX: Bid Ask 1m Money Markets: Borrowing Lending
S(AUD/NZD) 0.9175 0.9185 Australia 1.675% 1.575%
F1m(AUD/NZD) 0.9174 0.9184 New Zealand 1.840% 1.740%
FX Option: NZD Call / AUD Put Premium (AUD)1 NZD Put / AUD Call Premium (AUD)1
1 month K = 0.9250 0.0076 1 month K = 0.9250 0.0144
1FX option premia are quoted in AUD required to purchase the stated option per 1 unit of NZD.
5. State which option contract (NZD call / AUD put or NZD put / AUD call) LCP would purchase if they want to hedge their currency risk for this transaction. (1 mark)
6. For the two hedging alternatives LCP are considering, which alternative has the lowest maximum possible downside for LCP given the uncertainty regarding whether the deal completes? Brieﬂy explain your answer. (1 mark)
7. Suppose they purchase the option contract you suggest in Q5 and the deal completes. Carefully plot the total AUD deal cost for LCP in one month’s time. Be sure to include all relevant details in this plot. (3 marks)FNCE90016: International Financial Management Assignment.