Project #4: Forecasting Exchange Rates Group #3: Kristin Olson Chris Kline Wiley McCreedy 6/30/09

The Spot Rate Starting Point -For all forecast models used in our analysis our common starting point is the USD/AUD spot rate as follows: On June 26th, 2009 the Australia Dollar was trading with the following spot rate: American Terms: USD/AUD European Terms: AUD/USD

Forecasting Method #1: Asset Choice Model For this model we will incorporate three elements of the Australia environment into an analysis to forecast the exchange rate 6 and 12 months from now. These elements include: 1.Interest Rate Differential (impacts) 2.Possibility (and impact) of Carry-Trade Strategy 3.Possibility (and impact) of Government Intervention We will attempt to quantify each of these elements in terms of either an appreciation or depreciation of the AUD for the time periods specified.

Forecasting Method #1: Interest Rate Differential Impact If the US Federal Reserve increases interest rates, which it may have to in order to control liquidity from the stimulus, this may impact the AUD exchange rate with upward pressure as the differential grows considering Australia is aiming to keep its cash rate stagnant. 5.25% 4% $ $ As seen in the chart above an increase of 1.25% in the differential increased the USD/AUD exchange rate by 9.97%. If this follows and the Fed increase rates by.25% an expected increase in the exchange rate would be 1.99%. This will be included in our asset choice forecast.

Forecasting Method #1: Carry Trade Impact Nov 07: $ March 06: $ With talks of a potential revival of carry trade strategy as spreads in interest rates grow post the global recession, it is important to quantify a potential impact such a strategy would have on the AUD. The most recent example is the carry trades between the JPY and AUD between 2005 and The build up (thus greater demand for AUD) of this is seen in the chart. As a result of the carry trade strategy and its impact on the demand for the AUD we saw from early 2006 to late 2007 an increase of 33% in appreciation for the USD/AUD. If this holds and a strategy exists in the next 12 months we will see similar impacts that are accounted for in our asset choice model.

Forecasting Method #1: Government Intervention Impact -It is clear that the leadership of the Australian government and monetary policy holds strong on the strength of their export sector and its revival as the global recession ends. If they do in fact see this as pivotal to their comeback, they will need to keep the exchange rate low or risk an adverse effect on their exporting capabilities. -According to the Reserve Bank of Australia they currently carry billion AUD in their reserve fund. They could use this as a form of direct intervention to increase the supply of AUD in the forex markets and thereby place downward pressure on the exchange rates. -The impact of this is measured by comparing it to New Zealand intervention during the summer of They sold 120 million kiwi and for a temporary period decreased the value by 1.33%. Because of its large reserves a potential impact double this by Australia will be included in our asset choice model.

Forecasting Method #1: Summation of Impacts As discussed we expect that three elements (interest rate differential, carry trade strategy and government intervention) are plausible impacts on the exchange rate in the next 12 months. We quantify these elements in the following fashion: ElementPossibilty %Absolute impactWeighted impact Interest Rate Differential100%1.99% appreciation Carry Trade25%33% appreciation8.25% appreciation Government Intervention80%2.66% depreciation2.128% depreciation TOTALSN/A 8.112% appreciation Therefore, the asset choice model indicates: 1 year change in AUD = $ x = year spot AUD = $ = $ month spot AUD = $ ( /2) =$.83797

Forecasting Method #1: Purchasing Power Parity Model -The PPP model assumes that exchange rates will change to offset relative prices levels between countries and that the change will correspond equally with the inflation differential between the two countries: United States expected inflation (12 month):1.94% Australia expected inflation (12 month):2.25% Differential:0.31% Given this, the expected depreciation of the AUD per the PPP is as follows (6 and 12 month forecast): PPP Spot USD/AUD Forecast 1 year change in AUD: $ x.0031 = year spot AUD: $ = $ month AUD: $.80531– ( /2) = $.80531– = $.8041

Forecasting Method #1: International Fisher Effect The IFE model assumes exchange rates will change in proportion to relative differences in longer term interest rates as follows: Assume: Current USD/AUD spot rate:$ Current 1 year Australian Government Bond rate: 3.41% Current 1 year U.S. Government Bond rate: 0.43% Differential:2.98% IFE Spot USD/AUD Forecast as follows: 1 year change in AUD = $ x = year spot AUD = $ = $ month spot AUD=$ ( /2) = = $.79331

Forecasting MethodS #1-3: SUMMARY OF FORECASTS By testing the three theories prior (asset choice, purchasing power parity and international fisher effect) we come to the following forecast conclusions for the AUD in the next 6 and 12 month periods: ModelCurrent Spot USD/AUD 6 month spot USD/AUD % change12 month spot USD/AUD % change Asset Choice Model $.80531$ %$ % Purchasing Power Parity $.80531$ %$ % International Fisher Effect $.80531$ %$ %

Forecasting Methods: Our Recommendation -When considering which model to recommend as our assurance to MNC’s in the global arena it is important to remember that our time periods (6 and 12 months) are in the longer middle term. -Given this and the fact that both the IFE and PPP have shown that they are unsuccessful in accounting for short term unexpected deviations, we recommend our asset choice model and the implications it has for the AUD exchange rate over the next 12 months. -The asset choice model is successful in considering unexpected deviations at a time when there is no clear precedent for expectation. The revival from the global recession will be a tumultuous period and sticking to possibly outdated and simplistic models may deem adverse for any MNC operating in the global sphere.

Advisement to MNC #1 Our first client, MNC #1, is facing two significant short positions with the AUD in 6 and 12 months, meaning they will need to buy AUD at these time periods. Our recommendation is the following: -The MNC hedge this position given the uncertainty of the global economy at this time. -The MNC do so with an options call contract. -This options contract will give them the flexibility to: a) Capitalize off a depreciation of the currency and receive more AUD for less USD b) Protect their firm from a significant appreciation of the AUD as the asset choice model indicates.

Advisement to MNC #2 Our next client, MNC #2, is facing two significant long positions with AUD in the next 6 and 12 months meaning they will be looking to sell AUD at those specific time intervals. Our recommendation is the following: -The MNC hedge this position given the uncertainty of the global economy at this time. -The MNC do so with an options put contract. -This options contract will give them the flexibility to: a) Capitalize off a appreciation of the currency and receive more USD for less AUD. b) Protect their firm from a significant depreciation of the AUD given any factors the asset choice model does not anticipate.

Project #4 Resources Data and charts on exchange rates: Data on interest and inflation rates: (various articles in news section) Information on Australia reserves, etc. Reserve Bank of Australia Carry Trade Strategy Information: -case study by Professor Palmer on New Zealand intervention in forex markets