Part II Exchange rate behaviour

2000_Jun
2001_Jun
2002_Jun
2003_Jun
2004_Jun
2005_Jun
2006_Jun
2007_Jun
2008_Jun
2009_Jun
2010_Jun
2011_Jun

Country
A
A units :1B
interest
CPI
0.62
5.14
92.09
0.68
5.56
92.88
0.71
4.19
94.40
0.61
3.68
95.66
0.55
3.33
97.02
0.53
4.25
98.60
0.56
4.10
100.52
0.51
4.58
103.24
0.50
5.13
105.50
0.69
3.51
108.66
0.62
2.52
112.44
0.64
2.58
116.79
Note: CPI = Consumer Price Index

Country
B
Interest
5.95
5.62
1.74
1.29
1.06
2.61
4.56
5.32
3.84
1.02
0.20
0.30

CPI
86.70
89.93
91.00
93.51
95.41
98.12
102.07
104.18
108.66
108.55
111.38
112.91

C units:1B

0.56
0.68
1.31
1.64
1.34
1.33
1.32
1.42
1.17
1.64
1.49
1.54

Country
C
interest
38.10
60.42
59.23
45.46
26.22
21.50
19.96
23.53
21.19
21.17
15.87
12.90

You are required from the above table to:

a) Calculate the annual inflation rate in countries A, B and C
b) Calculate the exchange rate between Country A and Country C for all the
years given in terms of A units:1C
c) Calculate the annual forward rate for country As exchange rate with country
B over the 10 years and explain why you are able to apparently calculate the
future exchange rate.
d) Apply Purchasing Power Parity Theorem to countries A and C and analyze the
differences.
e) Apply the International Fisher Effect to countries A and C and analyze the
differences.
f) Calculate and explain the relevance of real interest rates.
g) Using the data above illustrate the relationship between the International
Fisher effect and Purchasing Power Parity over the last 10 years of data.
h) What has happened to the purchasing power of Currency A with regards to
Country C over the last 10 years of data?
i) XXplc invests in country B and purchases goods from country C. Analyze the
risks that it faces.
Note: You may wish change the countries A for B etc

CPI
27.11
36.85
63.82
80.67
89.21
97.45
105.18
115.63
125.08
136.96
148.17
154.79

Answer guidance notes

a) Copy and paste into Excel. The simple average annual inflation rate is for A =
2.2%; B = 2.4% and C = 18.5%. Alternatively the average compound rate is
A= (ln(116.29) ln(92.09))/11 = 2.1% similarly for B = 2.4% and C = 17.2%
so 27.11 x (1.1716)11 = 154.79 where 17.16% is the exact rate.
b) The rates are in terms of A units to 1C
2000_Jun
1.1071
2001_Jun
1.0000
2002_Jun
0.5420
2003_Jun
0.3720
2004_Jun
0.4104
2005_Jun
0.3985
2006_Jun
0.4242
2007_Jun
0.3592
2008_Jun
0.4274
2009_Jun
0.4207
2010_Jun
0.4161
2011_Jun
0.4156
c) The forward rates are:
Date

Forward rate

2000_Jun
2001_Jun
2002_Jun
2003_Jun
2004_Jun
2005_Jun
2006_Jun
2007_Jun
2008_Jun
2009_Jun
2010_Jun
2011_Jun

0.472026068
0.447455429
0.464578911
0.434791695
0.450257487
0.454753086
0.485961987
0.431763944
0.433740408
0.589435504
0.548566497
0.581498671

d) An application of PPP:
eC

2001_Jun
2002_Jun
2003_Jun
2004_Jun
2005_Jun
2006_Jun
2007_Jun
2008_Jun
2009_Jun
2010_Jun
2011_Jun

A inflatn %

error / risk
premium *

B inflatn

-9.68

0.86

35.93

25.39

-45.8

1.64

73.19

25.75

-31.37

1.33

26.4

-6.3

10.35

1.42

10.59

19.52

-2.91

1.63

9.24

4.7

6.46

1.95

7.93

12.44

-15.34

2.71

9.94

-8.11

18.99

2.19

8.17

24.97

-1.55

9.5

4.95

-1.1

3.48

8.18

3.6

-0.13

3.87

4.47

0.47

* represents higher returns from investing abroad due

possibly to higher risk

e) An application of IFE
A
interest

B
interest

-9.68

5.14

38.1

23.28

-45.8

5.56

60.42

9.06

-31.37

4.19

59.23

23.67

10.35

3.68

45.46

52.13

-2.91

3.33

26.22

19.98

6.46

4.25

21.5

23.71

-15.34

4.1

19.96

0.52

18.99

4.58

23.53

37.94

-1.55

5.13

21.19

14.51

-1.1

3.51

21.17

16.56

-0.13

2.52

15.87

13.22

eC

2001_Jun
2002_Jun
2003_Jun
2004_Jun
2005_Jun
2006_Jun
2007_Jun
2008_Jun
2009_Jun
2010_Jun
2011_Jun

error / risk
premium *

* a positive represents higher return from

investing abroad in Country C

f) Real interest rate is the interest less inflation

For C as an example:

Date

real
interest
rate in C

2001_Jun
24.49%
2002_Jun
-13.96%
2003_Jun
19.06%
2004_Jun
15.63%
2005_Jun
12.26%
2006_Jun
12.03%
2007_Jun
13.59%
2008_Jun
13.02%
2009_Jun
11.67%
2010_Jun
7.69%
2011_Jun
8.43%
Investing was well rewarded in an economy with high inflation and hence low
confidence in the future value of the currency. The high real rate serves to try
to overcome this anxiety.
g) Compare the errors in sections (d) and (e)
h) Change in purchasing power = change in value of home currency + home
inflation foreign inflation. In this -153.69% 140.63% + 25.74% - 320.05%
case, the very much higher inflation rate in C has not been offset by inflation
in A or the fall in the value of Cs currency.
i) From county C we know that the goods become more expensive, investing in
B we can see by inspection that the interest rate is lower in B yet the value of
the currency in B has not risen to compensate, so returns are lower.