International Finance Assignment

Introduction

You will be asked to perform two major tasks in this individual assignment. The first task is to analyse trends in Australian dollar. The second task will provide youan opportunity to collect exchange rate and economic data, and use this data to forecast short-term exchange rates. In the context of your results, you will be required to discuss the determinants of exchange rates and issues associated with forecasting exchange rates.

Important Information

• The assignment must be attempted and completed individually
• Use the university cover page when submitting reports
• Any assignment submitted late will be penalised at a rate of 10% per day
• Maximum word limit is 1,200-3,000 words in total to be written using Microsoft MS word. The table of contents and reference section are not included in the word count.
• 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.)The Excel work file is to be sent to [email protected]
• Upload the report through turnitin and provide a hard copy at the lecture on the due date. Please make sure your tutor's name appears on the cover sheet.
• Make and state any assumptions if the given information is insufficient to justify your answer.

Assignment Questions

1) Broad trends in the Australian Dollar. Evaluate trends in the Australian dollar / United States dollar (AUD/USD) exchange rate and the trade-weighted index (TWI) over the period from July 2001 through June 2016 (i.e. 15 years). Discuss whether the trends are consistent with theory.

2) Exchange rate prediction

a) Building on the insight you gained from Part 1, formulate a regression model forquarterly changes in the AUD/USD. Use this model to forecast the exchange rate at 30 September 2016.The prediction should be made at the end of June (i.e. using data at the end of June). This means that all variables are assumed to be available up to 30th of June. Your dependent variable will be quarterly changes in the AUD/USD exchange rate. Potential explanatory variables include differences in interest rates, differences in unemployment rates, and differences in inflation rates. Explain any issues you faced in selecting the data.

b) Forecast the AUD/USD exchange rate at 30 September 2016 using atime-series model.

c) Discuss how your forecasts compare with actual exchange rates at 30 September 2016? Does it outperform a random walk? Which is the most accurate model? Reflect on your forecasting models by evaluating the performance of the two prediction models in the context of the theory of exchange rate determinants.

Potential references and useful reading

Following are some potential references and useful readings/background reading. Students should feel free to go beyond these references.

Reserve Bank of Australia (2016) "The Exchange Rate and the Reserve Bank's Role in the Foreign Exchange Market" available at http://www.rba.gov.au/mkt-operations/ex-rate-rba-role-fx-mkt.html[this article provides a good high-level overview of what the RBA thinks influences exchange rates, see section 3]

Gruen D (2001), 'Some Possible Long-term Trends in the Australian Dollar', RBA Bulletin December, pp 30-41. Available at http://www.rba.gov.au/publications/bulletin/2001/dec/pdf/bu-1201-5.pdf[this article is a little outdated, however it gives some additional insight into what the RBA thinks is driving the AUD/USD, at least for the period to 2001]

Taylor, A. M., & Taylor, M. P. (2004).The Purchasing Power Parity Debate. The Journal of Economic Perspectives, 18(4), 135-158. [This gives a nice account of the history of PPP without being overly technical. Since this time there has been some more advances in the modelling of exchange rates, however the main issues are outlined in this paper. Also note that the best way to find this article is to go into Newcat>Journals> Journal of Economic Perspectives, or google the title for similar versions of this article from NBER]

Hambur J, L Cockerell, C Potter, P Smith and M Wright (2015), 'Modelling the Australian Dollar', RBA Research Discussion Paper RDP2015-12 Available at http://www.rba.gov.au/publications/rdp/2015/2015-12.html[this article has some more technical aspects, don't get bogged down here, focus mainly on the introduction and the literature review]

The lecture materials are also a useful guide, in particular weeks 5 and 6.

Potential sources for data

Historical spot exchange rates for AUD/USD, Australian interest rates and Australian balance of payments can be found in the following link: 
http://www.rba.gov.au/statistics/historical-data.html#exchange-rates

Current forward rates can be found in the following link:
http://www.cmegroup.com/trading/fx/g10/australian-dollar.html

US Interest Rates can be obtained from the Federal Reserve at:
https://apps.newyorkfed.org/markets/autorates/fed-funds-search-page

or from:
http://www.federalreserve.gov/releases/h15/data.htm

Historical U.S. unemployment rates can be found at:
http://data.bls.gov/timeseries/LNS14000000

Historical Australian unemployment rates can be found at:
http://www.abs.gov.au/AUSSTATS/[email protected]/DetailsPage/6202.0Apr%202016?OpenDocument#Time

U.S. Inflation data can be obtained from:
https://research.stlouisfed.org/fred2/series/CPIAUCSL

Australian inflation data can be obtained at:
http://www.abs.gov.au/AUSSTATS/[email protected]/DetailsPage/6401.0Mar%202016?OpenDocument