International Financial Management Assignment

FNCE90016: International Financial Management Assignment Semester 1, 2020

Instructions

This is an individual assignment.

The due date is 5pm May 15, 2020.

Assignment submission is via the LMS Assignment Submission link for all written assignments. Please refer to the Turnitin section of the LMS website for detailed submission instructions if needed: http://go.unimelb.edu.au/zax6. You must write up and submit your assignment as a Microsoft Word document (this software is available to all University of Melbourne Students to download onto your device — see: https://ask.unimelb. edu.au/app/answers/detail/a_id/6077/~/microsoft-office-365 for details), or via the text or Office 365 submissions options on the LMS Assignment Submission page.

A cover sheet including the following details should be included: Subject Code, Subject Name, Student Number.

The word limit is 2,000. Each table and figure counts for 200 words towards this limit. Please note one figure with multiple sub-plots only contributes 200 words to the limit. You do not need to reach the word limit to achieve full marks for this assignment.

You may discuss the assignment with other students but each student must write up their own independent answers. All answers will be checked via the standard Turnitin Plagiarism Review.

The assignment is marked out of 20. The contribution of each question is contained in parenthesis below the question.

This assignment is worth 20% of your final grade for this subject.

Requests for assignment extensions should be submitted here: https://fbe.unimelb. edu.au/students/bcom/current-students/assessment. Before completing this form, please read the Assignment Extension Policy, which can be found at: http://policy. unimelb.edu.au/MPF1326#section-4.37.

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). 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.

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).

  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).
    • The simple difference in the quarter-on-quarter inflation rates between the US and Australia: πtUS πtAus (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.
    • The simple difference in three month interest rates in the US and Australia: iUSt iAust (we will refer to this as the interest rate differential).
    • 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)

  1. 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)
  2. 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.
    • 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 = πtUS πtAus, in time t:

st = απ + βππt + 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.

  • 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, ∆ :
st = αi + βiit−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)

  1. In one paragraph, summarize your findings from part 3 regarding UIRP and PPP. (2 marks)

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

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.

  1. 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)
  2. 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)

  1. 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)

[1] The assumption that realized inflation is a good proxy for inflation expectations can be justified by an assumption that agents have perfect foresight regarding inflation.