FINS3616: Exchange Rate Forecasting Exercise 2019 Term 1 Assignment

Scenario

You are part of a team evaluating foreign investment opportunities for your company. An important component to the valuation is forecasting future exchange rates. You are based in Euro Zone and the investment opportunity is in the United Kingdom .

You decide to build a regression model that can be used to estimate future exchange rates using economic data. You expect that future exchange rate changes depend on a number of economic variables such as the two countries’ real GDP growth rates, the di erence in in ation rates, and the di erence in long-term interest rates between the two countries.

Instructions

Follow the steps below for the analysis. The base currency is EUR and the quoted currency is GBP.

Use the estimated coe  cients from your regression model to forecast the future exchange rates.

Report all your answers as decimal values. If your answer is 1.23%, report 0.0123, not 1.23.

Data Collection

Obtain market exchange rates for the period starting on the rst quarter of 2000 through the fourth quarter of 2017. Use calendar quarters (i.e. March, June, September, December). So you may validate that your data is correct, answers are provided in parenthesis to several questions. You want to know the amount of GBP per EUR.

1. What is the average exchange rate? (0.76 GBP per EUR)

Obtain quarterly data on the year-on-year percentage change in real GDP for the two countries in your country pair. Using the year-on-year change allows you to measure GDP growth relative to the same quarter last year, which takes into account seasonal e ects.

2. What is the average quarterly year-on-year percent change in real GDP for Euro Zone ? (0.0136)

3. What is the average year-on-year percent change in real GDP for the United Kingdom?

Obtain quarterly data on the year-on-year percent change in CPI for both countries. This is your measure of in ation.

4. What is the average quarterly in ation rate for Euro Zone ?

5. What is the average quarterly in ation rate for the United Kingdom? (0.0203) Obtain quarterly data on long-term interest rates for both countries.

6. What is the average quarterly interest rate for Euro Zone ? (0.0289)

7. What is the average quarterly interest rate for the United Kingdom?

Qualitative Analysis

Plot the market exchange rate over your sample period and take a closer look at the nancial crisis period (2008-2009).

8. What was the e ect of the crisis on the currency markets?

Analysing the Determinant of Exchange Rates

You want to estimate how the future exchange rate will change in one quarter, in one year, and in three years. To do so, you will need to construct three additional columns in your spreadsheet. These will consist of the future exchange rate changes for every quarter t, calculated as:

You should have some empty rows in your dataset as you will not be able to calculate future exchange rate changes for the last 1, 4, or 12 quarters in the sample.

9. What is the one quarter change in exchange rates from 2000 Q1 to 2000 Q2?

10. What is the one year change in exchange rates from 2000 Q1 to 2001 Q1?

11. What is the three year change in exchange rates from 2000 Q1 to 2003 Q1?

Calculate the long-run interest rate di erential (r_home r_{f oreign}) between the countries in your assigned country pair, as well as the in ation rate di erential (i_home i_{f oreign}). Use Euro Zone as the home country and the United Kingdom as the foreign country.

12. What is the average interest rate di erential?

13. What is the average in ation rate di erential?

Use the information you have collected to estimate a model for future exchange rate changes. You want to forecast exchange rate changes for di erent time horizons, so you will need three regressions which have the exchange rate change in one, four, or twelve quarters from now as the dependent (Y) variable. To identify which of the economic variables has the most predictive power, you include the di erence in in ation rates, the di erence in long-term interest rates, and the countries’ real GDP growth rates as independent (X) variables. The regressions will then estimate coe cients that measure the average e ect of each of these determinants on exchange rates:

Change¹_t^qtr =  ₀ +  ₁Interest Rate Dif f erential_t +  ₂Inf lation Dif f erential_t

+  ₃GDP Growth Home_t +  ₄GDP Growth F oreign_t + _t

Change¹_t^yr =  ₀ +  ₁Interest Rate Dif f erential_t +  ₂Inf lation Dif f erential_t

• ₃GDP Growth Home_t + ₄GDP Growth F oreign_t + _t

Change³_t^yr =  ₀ +  ₁Interest Rate Dif f erential_t +  ₂Inf lation Dif f erential_t

• ₃GDP Growth Home_t + ₄GDP Growth F oreign_t + _t

14. Interpret the signi cance of the estimated coe cients. Which predictors are signi cant for each forecasting horizon?

15. Do the signs of the coe cients make sense?

Forecasting Exchange Rates

You now want to forecast the future exchange rate changes from 2017 Q4 to 2018 Q1 , 2018 Q4 , and 2020 Q4 . Use the economic data (i.e. in ation rates, interest rates, real GDP growth) for 2017 Q4 and the regression coe cients from your estimations above to make the forecasts.

16. What is the expected change in exchange rates for 1 quarter?

17. What is the expected change in exchange rates for 1 year?

18. What is the expected change in exchange rates for 3 years?