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1. TASK OVERVIEW Lecture week 4 introduces the concept of arbitrage and parity theories – interest rate parity (IRP), purchasing power parity (PPP), and international Fisher effect (IFE). Lecture 3 introduces the foreign currency market, its equilibrium condition, factors affecting the exchange rate, why the government controls it, and how government interferes in the foreign exchange market. Building on the concepts primarily related to Week 3 and 4, this Exchange Rate Report aims to test and expand your understanding to assess whether IRP, PPP, and IFE hold in the forex market regarding the AUD/USD pair over the past five years. 2. MAJOR TASK DETAILS Background Work - Data Collection Background Work - Data Collection The task requires you to collect the following data from various open sources. • Collect monthly spot exchange rate between AUD/USD pair over last five years (60 data points) • Collect quarterly future exchange rate1 between AUD/USD pair over last five years over las five years (20 data points). Convert quarterly data points into monthly data (60 data points) using the interpolation method. • Collect the monthly interest rate and inflation rate for both the USA and Australia. Helpful Data Sources: 1 Note that ideally you would require forward rate not future rate to test interest rate parity. But the data on forward rate is difficult to obtain from a public and free data sources. Hence, you will use future rates as an approximation of forward rates to determine the forward premium or discount. Please note this limitation in the appropriate section of your report. Research Report International Financial Management Yahoo Finance (https://au.finance.yahoo.com/quote/AUDUSD%3DX/history?p=AUDUSD%3DX) Barchart https://www.barchart.com/futures/quotes/A6*0/historical-prices?viewName=main Reserve Bank of Australia – for monthly interest rate and inflation rate in Australia. Federal Reserve Bank for monthly inflation rate (https://fred.stlouisfed.org/graph/?g=1ED0) & monthly interest rate (https://fred.stlouisfed.org/series/DGS3MO#0) in the USA. You can also use other sources that you find more convenient. Summary statistics You are required to analyze the mean, median, and volatility of each data series. You are required to use graphs for meaningful visualization of your data series. Examining the Behavior of the Exchange Rate Present a meaningful economic explanation of the trend of the AUD/USD spot exchange rate. What are the main factors that explain the changes in the value of the Aussie dollar against the USD during the last five years? You are required to use the relevant factors that explain the variation in the exchange rates. These include economic factors – trade and finance related, government intervention, political factors, government policy regulations, etc. You are expected to spend significant time in this section. Evaluating the Future Exchange Rate Examine the trend of spot exchange rate and future exchange rate. Do you find any links between these two rates? Identify whether the future exchange rate includes a discount or premium for each monthly period (total 60 months)? Present your result in a table or a graph. Note that while forward rates and future rates are not the same, you can use these terms interchangeably for this assignment for the data limitation mentioned earlier. Testing IRP, PPP, and IFE Using the last five years (60 data points), examine whether IRP, PPP, IFE holds. Present your result in tabular and graphical form. What are the implications you can draw from your analysis about potential actions by market participants (MNCs, Banks, forex traders)? Note: Since you will have quarterly future rate data from public sources, you will use the linear/nonlinear interpolation method in Excel / Number or other data analyzing software to fill the missing data to generate monthly future rates. If you are unsure of what is interpolation, and how to do that in Excel / Number, please visit credible websites to take help. Research Report 3. DETAILED REPORT & STRUCTURE Cover Page Create a professional cover page. You are training to be a professional. See the cover page of a report by IMF. It is simple but professional. You can click the image and see the full report. I want you to draw inspiration from this or similar reports to prepare your cover page. Table of Contents The table of contents presents the main headings and the subheadings of each topic/chapter/section. Ideally both the main headings and subheadings should be hyperlinked to the respective page. It should label the page number for each section as well. Executive Summary The executive summary should contain a summary of key highlights of the report. Introduction This section should highlight the background of this report – why you are preparing this report, what is the main focus, what this report wishes to achieve, and what is your main take always (findings), etc. Please keep it short. Data and Summary Stats This section should highlight the nature of the data, data frequency – monthly, quarterly, or yearly; what are the variables you collected, a very brief definition of each variable, what are your data source for each variable, etc. It should also highlight if you have used an alternative measure to define a variable i.e. future rate for forward rate etc. You should also mention briefly if you have used any techniques i.e. average, interpolation, or extrapolation to convert data in a different frequency than what the original data has been. It should also report the summary stats table. Provide summary stats of each variable, any correlation among the variables, etc. Any initial inference about the variables and potential implications for the exchange rate behavior. Exchange Rate Behavior This is an important section. Students are expected to provide the economic explanation not just in the theoretical sense but in the applied sense to justify the behavior of exchange rate movements in the spot market over the period. The use of meaningful graphs is key to set the context to expand the economic arguments. You are required to explain the major trends and intermediate trends that you observe in the sport rate movement during the last 5 years. A significant part of this section requires students to research online from credible sources i.e. Federal Reserve System, Reserve Bank of Australia, reputed news articles Research Report International Financial Management Prepared by Dr Muhammad Al Mamun for IFM Students Page 4 of 7 to identify policy measures – regulatory, economic, and political – undertaken by the respective governments that explain the behavior of exchange rate movement. It is important to note that policies taken by other countries can also affect the AUD/USD exchange rate. Similarly, investors’ confidence, sentiments, bilateral trade transactions can also affect the exchange rate. All this information can also be incorporated in explaining the behavior of the AUD/USD movement. Future Exchange Rate In this section, students should use the future exchange rate to examine the trend and determine how it diverges from the spot rate. Identifying any discount or premium for each monthly future exchange rate. Link the policy measures – regulatory, economic, and political - as the key factors in explaining whether the premium or discount is justified or not. The use of appropriate charts, graphs, and tables is also important. Testing IRP, PPP, and IFE The student should outline what is IRP, PPP, and IFE? How these parity theories are tested. What are the steps taken to test these theories using the last five years (60 data points) data? Use graphical presentation. If you are not sure how to create a four-quadrant scatter plot in Excel / Number, you can take help from YouTube. The focus should be given to articulate the potential implications that can be drawn from your analysis about potential actions by market participants (MNCs, Banks, forex traders, etc.). For example, whether speculation, covered interest arbitrage, increase in import and export are likely to take place due to lack of IRP, PPP, and IFE if observed in the data. Conclusion Please provide a summary of the report. Mention your key findings. Briefly outline the limitations of your analysis by highlighting further considerations that should have been incorporated, but were not possible for some justified reasons. References Follow APA style of referencing within the body of the text and in the reference section for all sources of information. Research Report International Financial Management Prepared by Dr Muhammad Al Mamun for IFM Students Page 5 of 7 Appendices This section should include any appendix tables, graphs that have not been presented in the text or the Excel / Number sheet. 4. ADDITIONAL FORMATTING NOTES • The report should be concise. • The main body should be around 1200 words + / - 5%. • A4 page, 1.5 spaced, professional font with size 12. • Use suitable color in a consistent way that improves visibility and consistency in your presentation [Consider vision impact in choosing color] • Make an appropriate decision regarding what to put in the main body of the report in addressing each section and what to put in the appendices or the Excel / Number file. For example, putting a large table in the body of the report is not a good choice, or missing a key table in the body of the report represents equally poor judgment. • Materials presented in appendices will not be considered for marking purposes. Markers will consult the appendices to check the authenticity and correctness of the information presented in the main body of the report. The absence of such support in the appendices / Excel / Number file will count against the mark. • Each table, figure, and graph should be self-explanatory. Readers should be able to understand what that particular table or figure is about and, what is the measurement scale and what it represents. See the graph from an IMF report, as an example. The graph has a caption, appropriate level data points, sources, any notes to help improve readability and understanding. • The Excel / Number file document should be neatly formatted. Use the separate worksheet in the same file for different tables, graphs, etc. Some graphs/tables that you will present in the main text should also be present in the Excel / Number file.