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ACFI3140 International Finance Assignment
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.
l The assignment must be attempted and completed individually
l Upload the report through turnitin
l Use the university cover page when submitting reports
l Any assignment submitted late will be penalised at a rate of 10% per day
l Maximum word limit is 3,000 words in total to be written using Microsoft MS word. The table of contents and reference section are not included in the word count.
l 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.)
l The Excel work file for both tasks needs to be sent to ACFI3140@gmail.com.
l Make and state any assumptions if the given information is insufficient to justify your answer.
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 demonstrate 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 have setup a prediction model last 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 2018. The prediction should be made assuming the current date is the January 1st of 2018. This means that the prediction is for a full year ahead exchange rate change. You can use any information available to you when you attempt the assignment but the exchange rates in this part do not represent the actual rates from the market.
The regression model you are to use has the following coefficients.
Change in exchange rates (CAD/AUD) = 0.0001 + 0.5723*GDP growth rate differential (CAD-AUD) + 0.4521*expected inflation rate differential (CAD – AUD)
In the regression model, the GDP growth rates and the expected inflation rates for the two countries must be used to generate the independent variables. The bid and ask rates for CAD/AUD are expected to change at the same rate as indicated by the 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 2018 (1/ Jan/ 2018), the spot rate of CAD/AUD was 1.0344 (bid) – 1.0352 (ask). You also checked the current FX quotes for the CAD/USD and USD/AUD currency pairs. The quotes were as below.
1 Months Forward
2 Months Forward
3 Months Forward
6 Months Forward
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.
1) Design 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. Provide a prediction for the expected CAD/AUD spot exchange rate at 31/Dec/2018.
C. Does an arbitrage opportunity exist if you use your predicted CAD/AUD rate and the FX quotes table for CAD/USD and USD/AUD? If so, what would be the profit?
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)
D. Discuss ways you can test the performance of your model and ways to improve the performance of your model.
Historical spot exchange rates for AUD/CAD can be found in the following link:
A list of products used to calculate the Consumer Price Index (CPI) is in the following link:
Australian Bureau of Statistics (CPI explanation)
OECD database (economic projections)