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Market Analysis and International Investment

Published: Last Edited:

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1-(A) From various editions of the Economist, collect time series data of Big Mac prices for 3 countries and assess whether Purchasing Power Parity (PPP) holds. Discuss whether the (Big Mac Index) is a good Price index to be used in this analysis.

Answer:

The economist’s Big Mac index shown in table 1 has been used since 1986 as an indicator aimed to assess how PPP (Purchasing Power Parity) stands against most traded currencies such us the US dollar.

Before entering into further analyses, it is worth providing some relevant information on the PPP theory and assess whether the Big Mac index implicitly delivers points of comparison that subsequently reflect exchange rate parity conditions across 120 nations where this worldwide known burger is largely sold.[1]

Purchasing power parity theory by Rudiger Dornbush (Salamanca School) attempts to explain that two currencies adjust in compensation owing to the difference between the rates at which the two countries under watch are inflating. In relation to this, the underlying principle of the PPP theory lies in the law of a single price. This law can be simply explained based on the commodities trade whereby companies around the world tend to purchase goods from countries where these are more competitive in terms of price.[2]

Following this first hypothesis, there is a determination mechanism starting when goods are purchased abroad and at the same time the demand for foreign currency results in increasing the value of the currency and putting extra pressure on the price of the good itself. Based on this scenario, the PPP entails that two currencies should stand at a level where buying the same goods in the two countries is equivalent. Furthermore, the theory projects that real effective exchange rate will remain constant through time.

Based on further research, this work lays out some elements that intervene as potential culprits for not letting the PPP system operates over a short and medium-term horizon. As a relevant consideration to the findings and major setback to the PPP theory, the foreign exchange market framework has changed considerably over the last years moving exchange rates from fixed to floating. In the same context, capital movements and internal policies now explain differentials in exchange rates rather than a simplistic scenario of supply and demand of goods.[3] For instance, in 1973 the oil embargo led unexpectedly the United States, Japan and Italy to depreciating their currencies as a result of currency pressure.

According to Buiter and Miller (1992), the exchange rate accommodation mechanism has a much broader significance than the one explained by PPP’s scope; the exchange rate is a measurement of competitiveness as a progressive or “non-casual” variable. Therefore, exchange rate is a price that reflects an efficient international financial market as opposed to a predetermined state controlled through market forces exclusively.

Supporting the previous introduction and with regard to the Big Mac index headway between two years in a row, PPP does not always hold. Moreover, due to the composition of the product, Big Mac does not reflect a truthful price index to determine whether an exchange rate is undervalued or overvalued. According to the economist magazine, Big Macs are not cross-border trading goods as approximately 55% to 60% of the product costing is represented by non-traded goods such us labour, rent and services. Therefore, a price index with no dependence on international trading cannot fully reflect exchange rate comparisons; every country has a unique competitive position mainly produced by internal structures and factors such us labour market, productivity and purchasing capacity.

Purchasing power parity theory brings cear shortcomings and most of them can be determined superficially by the Big Mac index and its trend. The most commonly mentioned problems behind the use of PPP:

  • Trade Barriers
  • Changes in patterns of demand and output
  • Similar purchasing patterns and taste in products
  • Varying price indices
  • Taxation
  • Long-term vs. short-term outlook

Table 1 shows full coverage for the Big Mac index over a large group of countries. As a complementary part of the analysis this work has chosen two currencies to compare against the US dollar and determine the PPP trend between 2004 and 2005.

In 2004 the Big Mac price in the US was US$ 2.90 compared to US$1.26 in China and US$ 5.18 in Norway. In 2005 the corresponding prices represented an increment of the US price by 5.5% to US$ 3.06, 0.7% in China and 16.9% in Norway reaching prices of US$1.27 and US$6.06 respectively.

Following the PPP theory, it indicates that exchange rates move to rectify changes in inflation rates. In 2004 China’s currency was 57% undervalued and Norway 79% overvalued; the model expects that an inflationary process in the US of 5.5% would have generated a rectifying movement to close gaps. On the contrary, while the Big Mac price index in the US rose by 5.5%, China’s currency dropped further from 57% undervalued to 59% and Norway continued the other direction and got appreciated dramatically from 79% to 98%. If Big Macs could be exported, no buyers would be looking at Norway since its real international competitiveness is far below. However, in terms of purchasing capacity the Norwegians are potentially capable of purchasing Big Macs as their income per head is considerably higher than in US and China.

 

(B)Choose any two countries and collect (approximately) one year of daily data of a forward exchange rate, the spot exchange rate and the two corresponding interest rates. Can you make any arbitrage profits? Carefully discuss.

Answer:

To open the discussion about the exchange rate market and its relationship with interest rates, the answer introduces the concept of Eurocurrency market. This is a marketplace where participants make money through borrowing and depositing currencies at a price dictated by interest rates. In this regard, the transactions period varies as short as overnight and in some cases as long as five years.

For this exercise the answer considers one participant and two currencies, US Dollar and GBP based on data from 2005 central bank statistics. On January 31st 2005, this person borrowed US$ 18’833.000 in the US and made the decision to arbitrage in GPB pounds. Diagram 1.0 illustrates the foreign exchange arbitrage based on the use of financial instruments to generate profits.

Diagram 1.0

US $

Spot Sell $ 18’833.000

Borrow US$18 ‘833.000

Rate

£/$ 1.8833

Sterling Market

Buy: £10’000.000

Deposit: £(10’000.000)

Interest Rate : 4.83%

1 year

 

Interest Rate: 6.20%

1 year:

1YearRepay:$(18’833.000)

Interest: US$ 909.633

Total: $(19’742.633)

 

Receive £ 10’000.000

Interest: £ 620.000

Total: £10’620.00

Buy: US$ 19’742.633

Net: zero

£/£ 1.8526

Sell £(10’656.716)

Net -£ 36.716 loss

Source: Author calculations

  1. Borrowed at US$ 18’833.000 at 4.83% and one repayment at the end of the first year (365 day repayment of US$ 19’743.633)

Evaluate potential arbitrage:

  1. Sell US$ 18’833.000 to buy sterling pounds at GBP/USD 1.8833 and obtained £10’000.000
  2. Made deposit of £10’000.000 at 6.20% for 12 months and agreed to received £10’482.999
  3. Same take a forward contract to buy US$ 19’742.633 1year forward at sustaining GBP/USD at 1.8526 and sell: £10’657.256; losses: (£36.716)

The arbitrage would produce losses as USD appreciates against the US dollar on a 12-month period; you cannot make profits.

 

2-(A) Discuss the importance of the exchange rate as an economic variable for international investment decisions or for importers and exporters.

Answer:

Exchange rates are a key factor that concerning their mechanisms of adjustments and vulnerability originates differential positions and volatility risk within an economic outlook. In relation to this effect, Buiter and Miller’s approach (1992) explains that monetary policies combining prices stabilisation, capital freedom and rational expectations in the foreign exchange market produce a “transitional” effect on the level of international competitiveness and leave industry sectors exposed.[4]

For financial assets and exchange rates levels, international trade activities have rapidly evolved into a more developed and complex sector that operates freely within a global economic system and lead economies to frequently reaching higher levels of surpluses or deficits. On a daily basis scenario, portfolio strategist search for competitive positions worldwide that match investment targets. Concerning the structure of the investment, foreign exchange forecasts are a driving force at the stage of resources allocation and use of financial instruments (Derivatives).

But how the exchange rates intervene as a decisive economic variable and in which sectors they deliver benefits or vice-versa?

Milton Friedman gives his opinion to this question, starting by responding on the effects over exchange rates through monetary policies; he says “…..monetary policy actions affect asset portfolios in first instance, spending decisions in the second, which translate into effects on output and then on prices. The changes in exchange rates are in turn mostly a response to these effects of home policy (on output and prices?) and of similar policy abroad…..”[5]. If one assumed Friedman’s comments, domestic policies move exchange rates affecting decisions in a certain order.

With regards to international trade, one of the most compelling examples on how exchange rates affect the performance of particular sectors compared to others is the case of the British economy. On one hand an overvalued pound has jeopardised to some extent the lack of competitiveness of the industrial production and exports in the UK by soaring internal prices and changing the productive structure of the country. Conversely, on the other hand the levels of interest rates together with a strong currency have triggered capital inflows, which are being allocated on different asset classes and also in the continuous boost of service sectors (i.e. Financial Services).

To understand the mechanism linking imports and exports with exchange rates, Maurice Levi (1990) explains that on a supply and demand setting the supply curve of a currency illustrates the quantity of that currency supplied and the price of the currency, given by the exchange rate, the supply curve of a currency is calculated as a result of a country’s demand for imports. This event occurs when buyers pay for imports that are sold in foreign currency, then the country’s recipients of the goods must sell their domestic currency for the requested foreign exchange and when imports are invoiced in local currency the foreign beneficiary of the currency sells it. In any case imports result in the country’s currency being supplied. The amount of the currency supplied is equal to the value of imports.[6]

On the contrary, the demand curve for a currency shows the value of the currency that is demanded at each likely exchange rate. The need to buy a country’s currency takes off from the need to pay for the country’s exports; the currency’s demand curved is derived from the country’s export supply curve, which shows the volume of exports at each price of exports[7].

To summarise the answer, exchange rates send strong signals to both, portfolio investors and international traders; however the degree of the effect varies depending on the competitive position of the economy. In terms of traded goods, exchange rates place the level of international competitiveness of goods compared to the same goods in other country. On investment allocations such us bonds and equities, an exchange rates outlook is essential to sustain or withdraw positions.

In relation to investments, exchange rate risk is generated by uncertainty in the future exchange rates at which the asset or liability will be converted into dollars. Thus, bonds, foreign stocks, real estates and accounts receivable and payable may be subject to exchange rate risk if their value in home currency is beaten by exchange rates.

Concerning imports and exports of services such us tourism, banking services, consulting, engineering amongst others react to exchange rates variations in the same way as imports and exports of goods.

(B) Collect data for 3 countries of your choice and assess the importance of the exchange rate for international equity investors. Use different investment horizons.

Equity investors react to market sentiments, set out overall investment positions and individual strategies underpinned by economic forecasts. Decisions are based upon a group variables and future scenarios; for instance it is widely recognised the existing inverse relation between interest rates and equities. When interest rates are moved up by major central banks such us the Federal Reserve, European Central Bank (ECB), Bank of England and Bank of Japan, shares lose momentum and in most of the cases fall.

In terms of foreign exchange conditions, investors go long on equities when they feel comfortable with correct valuation of the currency and if the economy’s balance of payments works in line with the external position of the country. In other words, the exchange rate is determined by the aggregated equilibrium between currency demand and supply. If any country is not in the position to sustain its competitiveness on its currency it sends strong signal for investment decisions.

The following three countries US, UK and China have been selected to understand how bursaries respond or relate to changes in exchange rate:

US Dow Jones (1-Y Horizon)

 

US is a highly liquid market, Chart 1.0 shows market transactions above 2 billion US dollars a day sustaining levels over 1 year horizon. The Dow index moved up from 10500 (approx) in June 2005 growing by 3.8% (approx) to June 9th 2006. In chart 2.0 Euro gains grounds on the US dollar by almost 5% over the same period as shown on the Dow Jones outlook above. Thus, Euro appreciated by 5% against US dollar and Dow Jones with a slight growth without losing transaction levels. Hence, no particular direct correlation is found on the two variables (Exchange rate and Stock Index). However, it is relevant to clarify that more components such us interest rates expectations, unemployment levels in the US and Euro land, mortgage activities, retail index and companies profitability have an effect on these trends.

UK FTSE (2-Year Horizon)

 

In a 2-year Horizon, FTSE shows strong momentum soaring by 22% (approximately from 4500 to 5500); uptrend with a relevant drop in June 2006 due to oil prices and decision on interest rates accommodation by the FED and ECB. This analysis in terms of the pound outlook shows two scenarios for the currency. In 2004 starts at GBP/USD1.82 falling to its 18-month lowest level to 1.72 (5.8%), then it picks up again and in less than 5 months rebounds to 1.85. Again the analysis does not find a direct relationship between a positive steady FTSE trend and sterling variations.

CHINA Shanghai Composite 6-Month Horizon

 

The third example involves Chinese Yuan and US Dollar, which have experienced international trade growth five times faster than in 1990s decade. On one hand, Chinese moved from being the 9th most important destination for US Exports to being currently the 4th delivering an impressive uptrend in 2005 above 20% increase (United States Trade Representatives, 2006). On the other hand, the effect of Chinese exports has been stronger, in 2004 china’s trade surplus with the US increased by 24.5% to 202 billion US dollars, the largest between two economies according to the Economic Policy Institute in 2006.

Over the last 6 months, the Chinese Yuan has not followed a revaluation against the US Dollar; as it would have been expected due the international trade context explained before (only 2% appreciation). In relation to the Shanghai composite index, it has experienced spectacular growth outperforming other stock markets (44% increases in the same period).

Based on these figures, the analysis indicates, exchange rate is not the driving factor to buy stock in China; investors continue forecasting strong growth in Chinese listed companies due to strong internal market performance, domestic consumption as well as industry development.

3- Today is the 16th of December 1998.You are a small importer/exporter having to pay £5,000,000 on the 26th of February 1999.You are concerned about exchange rate risk and you are considering using currency futures to hedge your currency risk. What would be your hedged and unhedged outcome with hindsight? Carefully explain what will happen over this hedging period with your margin account. One Pound Sterling futures contract is £62,500 and the initial and maintenance margins are $2,295 and $1,700 respectively.

Answer: (Using spreadsheet “Market”) and concepts from Brian Kettell (Financial Economics p321-330)

In futures the principle is to sell what is overpriced and buy what is underpriced.

In this example if the GBP/USD is overpriced (futures) less US dollars per Sterling pounds you should sell the futures contract on February 26th 1999 (Long Position in the Spot Market), which means purchase GDP/USD at the Spot Rate

Spot Price Futures

GBP/USD 1.6750-08 1.6060-1.5998 (at a Premium)

The advice for the US importer is to protect the US value by hedging 80 contracts of Sterling Pounds using futures contracts. However, in this case the US dollar as of February 26th when the payment will be made, the futures price shows a US dollar at a premium, which means, the dollar will appreciate.

Action:

Unit of Trading £ Pounds

Go long in the future market selling your futures contract (right to deliver at 1.6060) and holding on at the the Spot Market.

Currency Hedge US dollar against British Pound:

£5.000.000 at a spot rate February 26th 1999:

Action buy future Contracts: £62.500

Number of contracts: 80

Value locked on December 16th 1998: £62.500 x 1.6750= US$ 104.687

Value of each futures contract on February 26th 1999:£62500 x 1.6060 = US$ 100.375

Net Profit of each contract: US$4. 312 x 80 = US$ 344.960 (Hedging profits)

At the end of the period, without hedging you would have benefited as US dollar got appreciated. However, with hedging you will obtain profit margins of US$ 4312 in each contract improving your initial margins.

Bibliography

Bank of England Statistics available at: http://www.bankofengland.co.uk/statistics/index.htm

Economic Policy Institute available at:

http://www.epinet.org/content.cfm/webfeatures_econindicators_tradepict20060210

The Economist Big Mac Index available at:

http://www.economist.com/markets/bigmac/displayStory.cfm?story_id=4065603

Federal Reserve Statistics available at:

http://www.federalreserve.gov/datadownload/Build.aspx?rel=H15

Kettell, B. (2001) Financial Economics, Making Sense of Market Information: Prentice Hall: London

Levi, M (1990). International Finance, the Markets and Financial Management of Multinational Business. McGraw-Hill Series in Finance: United States

MacDonald R, Taylor M, (1992). Exchange Rate Economics Volume I “Monetary Policy and International Competitiveness: The problems of adjustments Willem H. Buiter and Marcus Miller, Published by Edward Elgar: England

Walmsley, J. (1996). International Money and Foreign Exchange Markets, An introduction. Published by John Wiley & Sons Ltd Baffins Lane Chichester. West Sussex

 

Appendix

Appendix I. Daily Data

       

End month average

   

Daily forward

 

weighted interest

   

premium/discount

 

rate, instant

 

Daily average of 4

rate, 12 months, US

Spot exchange rate,

access deposit,

 

UK Banks' base rates

Dollar

US $ into Sterling

Bank branch accounts

 

IUDAMIH

XUDLDFY

XUDLUSS

IUMTHAI

04-Jan-05

4.75

-3.075

1.8833

n/a

05-Jan-05

4.75

-3.005

1.8881

n/a

06-Jan-05

4.75

-2.97

1.8754

n/a

07-Jan-05

4.75

-2.925

1.868

n/a

10-Jan-05

4.75

-2.905

1.8748

n/a

11-Jan-05

4.75

-2.85

1.877

n/a

12-Jan-05

4.75

-2.895

1.8932

n/a

13-Jan-05

4.75

-2.85

1.8806

n/a

14-Jan-05

4.75

-2.755

1.8684

n/a

17-Jan-05

4.75

-2.715

1.8593

n/a

18-Jan-05

4.75

-2.85

1.8669

n/a

19-Jan-05

4.75

-2.895

1.8769

n/a

20-Jan-05

4.75

-2.93

1.8706

n/a

21-Jan-05

4.75

-2.92

1.8693

n/a

24-Jan-05

4.75

-2.94

1.8757

n/a

25-Jan-05

4.75

-2.89

1.8647

n/a

26-Jan-05

4.75

-2.955

1.8815

n/a

27-Jan-05

4.75

-2.945

1.8864

n/a

28-Jan-05

4.75

-2.935

1.8829

n/a

31-Jan-05

4.75

-2.92

1.8859

2.18

01-Feb-05

4.75

-2.9

1.8799

n/a

02-Feb-05

4.75

-2.895

1.8848

n/a

03-Feb-05

4.75

-2.84

1.8794

n/a

04-Feb-05

4.75

-2.885

1.8858

n/a

07-Feb-05

4.75

-2.835

1.8657

n/a

08-Feb-05

4.75

-2.855

1.8561

n/a

09-Feb-05

4.75

-2.965

1.8578

n/a

10-Feb-05

4.75

-2.95

1.8712

n/a

11-Feb-05

4.75

-2.96

1.8654

n/a

14-Feb-05

4.75

-2.945

1.8869

n/a

15-Feb-05

4.75

-2.935

1.8872

n/a

16-Feb-05

4.75

-2.83

1.8786

n/a

17-Feb-05

4.75

-2.81

1.8906

n/a

18-Feb-05

4.75

-2.79

1.8944

n/a

21-Feb-05

4.75

-2.8

1.897

n/a

22-Feb-05

4.75

-2.9

1.9057

n/a

23-Feb-05

4.75

-2.985

1.906

n/a

24-Feb-05

4.75

-2.955

1.9077

n/a

25-Feb-05

4.75

-2.89

1.9153

n/a

28-Feb-05

4.75

-2.89

1.9257

2.18

01-Mar-05

4.75

-2.875

1.9198

n/a

02-Mar-05

4.75

-2.94

1.9101

n/a

03-Mar-05

4.75

-2.9

1.9084

n/a

04-Mar-05

4.75

-2.885

1.9258

n/a

07-Mar-05

4.75

-2.87

1.9139

n/a

08-Mar-05

4.75

-2.86

1.9311

n/a

09-Mar-05

4.75

-2.835

1.9212

n/a

10-Mar-05

4.75

-2.77

1.9236

n/a

11-Mar-05

4.75

-2.72

1.927

n/a

14-Mar-05

4.75

-2.64

1.9119

n/a

15-Mar-05

4.75

-2.61

1.9157

n/a

16-Mar-05

4.75

-2.65

1.9284

n/a

17-Mar-05

4.75

-2.595

1.9237

n/a

18-Mar-05

4.75

-2.555

1.9155

n/a

21-Mar-05

4.75

-2.515

1.8962

n/a

22-Mar-05

4.75

-2.465

1.8992

n/a

23-Mar-05

4.75

-2.235

1.8737

n/a

24-Mar-05

4.75

-2.29

1.8702

n/a

29-Mar-05

4.75

-2.25

1.8743

n/a

30-Mar-05

4.75

-2.19

1.8832

n/a

31-Mar-05

4.75

-2.19

1.8904

2.18

01-Apr-05

4.75

-2.245

1.8888

n/a

04-Apr-05

4.75

-2.2

1.8722

n/a

05-Apr-05

4.75

-2.205

1.8768

n/a

06-Apr-05

4.75

-2.235

1.8771

n/a

07-Apr-05

4.75

-2.17

1.8768

n/a

08-Apr-05

4.75

-2.11

1.8749

n/a

11-Apr-05

4.75

-2.125

1.8902

n/a

12-Apr-05

4.75

-2.115

1.8857

n/a

13-Apr-05

4.75

-2.175

1.8923

n/a

14-Apr-05

4.75

-2.23

1.8814

n/a

15-Apr-05

4.75

-2.28

1.8932

n/a

18-Apr-05

4.75

-2.39

1.9038

n/a

19-Apr-05

4.75

-2.49

1.9162

n/a

20-Apr-05

4.75

-2.47

1.9168

n/a

21-Apr-05

4.75

-2.36

1.9122

n/a

22-Apr-05

4.75

-2.305

1.9153

n/a

25-Apr-05

4.75

-2.245

1.9115

n/a

26-Apr-05

4.75

-2.175

1.9036

n/a

27-Apr-05

4.75

-2.235

1.9071

n/a

28-Apr-05

4.75

-2.205

1.9098

n/a

29-Apr-05

4.75

-2.225

1.91

n/a

30-Apr-05

n/a

n/a

n/a

2.18

03-May-05

4.75

-2.105

1.8907

n/a

04-May-05

4.75

-2.105

1.9021

n/a

05-May-05

4.75

-2.14

1.9046

n/a

06-May-05

4.75

-1.995

1.8926

n/a

09-May-05

4.75

-1.9

1.8828

n/a

10-May-05

4.75

-1.91

1.8838

n/a

11-May-05

4.75

-1.85

1.8742

n/a

12-May-05

4.75

-1.715

1.8639

n/a

13-May-05

4.75

-1.715

1.8556

n/a

16-May-05

4.75

-1.76

1.8348

n/a

17-May-05

4.75

-1.75

1.8393

n/a

18-May-05

4.75

-1.77

1.8344

n/a

19-May-05

4.75

-1.76

1.836

n/a

20-May-05

4.75

-1.7

1.8246

n/a

23-May-05

4.75

-1.68

1.8293

n/a

24-May-05

4.75

-1.68

1.8284

n/a

25-May-05

4.75

-1.685

1.8309

n/a

26-May-05

4.75

-1.67

1.8215

n/a

27-May-05

4.75

-1.64

1.8235

n/a

31-May-05

4.75

-1.635

1.8225

2.17

01-Jun-05

4.75

-1.765

1.8155

n/a

02-Jun-05

4.75

-1.655

1.817

n/a

03-Jun-05

4.75

-1.665

1.8164

n/a

06-Jun-05

4.75

-1.625

1.8193

n/a

07-Jun-05

4.75

-1.655

1.83

n/a

08-Jun-05

4.75

-1.6

1.8389

n/a

09-Jun-05

4.75

-1.53

1.8185

n/a

10-Jun-05

4.75

-1.445

1.8132

n/a

13-Jun-05

4.75

-1.425

1.8012

n/a

14-Jun-05

4.75

-1.52

1.8071

n/a

15-Jun-05

4.75

-1.53

1.8192

n/a

16-Jun-05

4.75

-1.5

1.8191

n/a

17-Jun-05

4.75

-1.525

1.8237

n/a

20-Jun-05

4.75

-1.52

1.824

n/a

21-Jun-05

4.75

-1.48

1.8262

n/a

22-Jun-05

4.75

-1.32

1.8226

n/a

23-Jun-05

4.75

-1.25

1.8194

n/a

24-Jun-05

4.75

-1.27

1.8219

n/a

27-Jun-05

4.75

-1.225

1.8262

n/a

28-Jun-05

4.75

-1.165

1.8172

n/a

29-Jun-05

4.75

-1.115

1.8046

n/a

30-Jun-05

4.75


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