Analysis and Forecast

of Exchange Rate

USD/AUD

International Finance

Lecturer: Wil Martens

Group member

Vu Duy Phat s3461583

Le Thao Ngoc s3480700

Le Duc Manh s3461882

Je Woo Nam s3481905

Vuong Minh Chau s3461886

Table of Contents

I. Executive summary .......................................................................................................................... 1

II. Introduction ...................................................................................................................................... 1

III. Theoretical framework ..................................................................................................................... 2

Relative inflation rates .......................................................................................................................... 2

Relative real interest rate ...................................................................................................................... 2

Relative GDP growth rate .................................................................................................................... 2

Capital flow .......................................................................................................................................... 2

Money supply ....................................................................................................................................... 2

Relative unemployment rate ................................................................................................................. 3

IV. Fundamental analysis ....................................................................................................................... 3

1. Quantitative analysis ........................................................................................................................ 3

Purchasing Power Parity (PPP) ............................................................................................................ 3

Uncovered Interest Parity (UIP) ........................................................................................................... 4

Original model ...................................................................................................................................... 6

Backward elimination ........................................................................................................................... 7

Sensitivity analysis of Backward Elimination model ........................................................................... 9

2. Qualitative analysis .......................................................................................................................... 9

V. Limitations...................................................................................................................................... 10

VI. Forecast exchange rate (See appendix) .......................................................................................... 11

VII. Conclusion ...................................................................................................................................... 11

VIII. Appendix ........................................................................................................................................ 12

IX. Reference ........................................................................................................................................ 16

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I. Executive summary

The purpose of the report is to determining the historical movement of the exchange rate of USD/AUD

and forecasting the rate on December 1st 2015.

In quantitative analysis, macro-economic factors between USA and Australia from 1996 to 2015 are used

to run the simple and multiple regressions. After using backward elimination, here is the final model with

the most significant factors:

In sensitivity analysis based on p-value and the final model above, the most significant factor affecting

the exchange rate is money supply M2 of USA. The following factors are unemployment rate differential

and time series respectively. Meanwhile, the inflation differential has the highest p-value, which is least

contribution to percentage change.

In qualitative analysis, the exchange rate of USD/AUD is directly affected by: RBA is expected to cut

the rate in the future; the FED decided to raise the interest rate for first time since the financial crisis; on

the 3rd

quarter, GDP growth beat the economist forecast; US current account deficit reaches highest level

since 2008; and finally, Iron ore drops to 10-year low.

From these approaches, the exchange rate is expected to be 0.72325 on December 1st. That means AUD

will depreciate (compared to 0.7233 on November 30th) and investor should sell AUD or invest in USD.

II. Introduction

Nowadays, the expansion of the international trade of the world causes the exchange rate between

countries to be highly concerned by international firms, investors and governments. As the exchange rate

is important and it is changing continuously, investors usually try to analyze and explain the factors that

determine the historical movement of it and forecasting the rate for hedging and anticipating risks.

The exchange rate of USD/AUD will be analyzed by illustrating macro-economic factors and time series;

through quantitative analysis, qualitative analysis and sensitivity analysis. Finally, the report will provide

some limitations of these analyzing methods and a forecasting for value of USD/AUD.

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III. Theoretical framework

Relative inflation rates

This factor is known as inflation differential, which is a key factor to determine the expectation on the

foreign exchange rate. There is a negative relationship between inflation differential and exchange rate. If

the inflation in the domestic country is higher than the foreign country, the price of domestic goods will

become more expensive than foreign goods. Thus, the demand for foreign currency for foreign goods

will rise while the supply for foreign currency will decrease, which results in a depreciation of domestic

currency.

Relative real interest rate

If the domestic real interest rate is relatively higher than foreign real interest rate, the capital inflows will

increase due to the attraction of the domestic financial asset. Hence, as the demand for domestic currency

increases and the supply for domestic currency decreases, the domestic currency will appreciate.

Relative GDP growth rate

A country with high GDP growth rate will be expected to have higher consumption because people

become wealthier. That leads to an increase in import and demand for foreign currency. Domestic

currency will depreciate. However, country with high GDP growth rate will be attractive to investors

because it is implied an expansionary economic trend. As a result, demand for domestic currency

increases and it will appreciate. Hence, change in GDP is ambiguous to the value of currency.

Capital flow

Capital flow explains the movement of money when investors want to invest into domestic or foreign

assets; capital flow can also be seen when there is a trade or business production occurring. Capital flow

is commonly used to evaluate the strength of capital market which directly affects the exchange rate.

Thus, capital flow is important factor for prediction of exchange rate.

A negative capital flow causes the higher demand for domestic currency. Thus, this will lead to an

appreciation of domestic currency.

Money supply

Due to different measure of money supply system, the regression used the M1 in Australia and M2 in the

US to measure the foreign exchange rate. (See appendix)

If the Money supply increases, it will cause the currency to be depreciated and vice versa. To illustrate,

during the time of Contractionary policy imposing by the government, the interest rate went up. High

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interest rate would benefit for traders as they earn interest from the interest rate. Thus, supply of foreign

currency increased that lower the exchange rate and resulting in an appreciation in domestic currency.

Relative unemployment rate

Unemployment rate can be seen as an indicator to understand the state of the economy. If unemployment

rate increases, consumption will fall because unemployed people have to limit their consumption. Thus, it

will lower demand for domestic currency. If the demand declines, the economy will slow down which

results in depreciation in domestic currency.

IV. Fundamental analysis

1. Quantitative analysis

Purchasing Power Parity (PPP)

Under the PPP equation,

. To stable the exchange rate with the concept of Random-Walk

behaviour, we will concentrate on the change in the exchange rate in forecasting. Thus, instead of using

absolute PPP (

), Relative PPP model will be applied and inflation differential factor is used to

determined the changes in exchange rate

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The formula illustrates the percentage change in the exchange rate will decrease by 34.75% for every unit

increase in the inflation differential. Because R square and adjusted R square are less than 1, proving that

there is a weak relationship between the exchange rate and Inflation differential. Besides, Multiple R=

0.1339 meaning only 13.39% percentage change in exchange rate is explained by this model.

PPP model is wider used in the short run only as it helps to revise the appreciation or depreciation of the

currency. However, in the long run, as inflation factor is taken out, PPP is not good model for illustration.

Uncovered Interest Parity (UIP)

Based on UIP equation: RUSD - RAUD = (EeUSD/AUD – EUSD/AUD)/EUSD/AUD, the nominal interest differential

is considered to affect the exchange rate change. Regression will be run with nominal interest differential

as an independent variable and percentage change in the exchange rate as a dependent variable in order to

analyze the strength of their relationship.

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The equation implies that the percentage change in the exchange rate will decrease 18.62% or each unit

increases in nominal interest rate differential.

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Multiple R=0.0884, which shows percentage change in the exchange rate is only 8.84% by the nominal

interest rate differential. Additionally, adjusted R squared=0.0036, which means only 0.36% of variation in

percentage change in the exchange rate can be explained by nominal interest rate differential.

Therefore, it is concluded that the nominal interest rate differential does not significantly affect the

percentage change in the exchange rate. Hence, the interest rate parity does not hold in forecasting the

movement of the currency.

Original model

After running the multiple regression, the outcome of the model will be:

From Residuals and Standardized Residuals graph below:

- Linearity: error terms are randomly spread.

- Independence of errors: the error terms are independent, they do not have any

relationship

- Normally distributed: error terms are normally distributed, since the histogram of

residuals has symmetrical bell-shape and evenly distributed around zero.

- Equal variance: error terms equally spread below or above the data (constant variance).

Hence, all assumptions are satisfied, it means exchange rate can be predicted by this model.

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Overall, it is a good model as p-value is less than 0.05( p-value = 0.0017). However, low adjusted R

Square and Multiple R indicate the model is not strong enough. Furthermore, there are many insignificant

variables that reduce the strength of model, only Ln(M2US) variable is significant . Thus, the Backward

Elimination will be taken into account.

Backward elimination

The backward elimination is the regression that runs on the original model to identify the most accurate

variables that affect the percentage change in exchange rate. The backward elimination has 95%

confidence level showing this result:

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Nine variables were chosen to run the backward elimination, but only inflation differential,

unemployment differential, logarithms of M2 US money supply and the time series are significant. The R

square and the adjusted R square are 0.0986 and 0.0832 respectively, meaning the final model is not

strong. The multiple R is 0.3141, indicating 34.41% percentage change in exchange rate is explained by

this model and the others are explained by other factors.

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Sensitivity analysis of Backward Elimination model

From the table, Ln (M2-US) contributes the most to the percentage change in the exchange rate (p-value

= 0.0005). Thus, exchange rate will affect significantly if money supply M2 changes. Meanwhile, the

inflation differential has the highest p-value, which is least contribution to percentage change. Besides,

unemployment rate differential and time series have p-value of 0.009 and 0.0113, respectively. Any

changes in these two variables will also cause a change in the exchange rate, but less power than money

supply M2.

2. Qualitative analysis

Event Reason Description

The RBA is

expected to keep

cutting the rate in

the future.

Keep the low

interest rate to

support borrowing

and spending.

According to RBA, after the meeting the Board

decided to leave the cash rate unchanged. However,

it is expected that RBA will continue cutting rates.

According to Emmett, keeping the rate low will

encourage the borrowing and spending. But in the

opposite it will not attract foreign investors. As a

result, the AUD will keep depreciating.

The FED decided to

raise the interest

rate for first time

since the financial

crisis (Appelbaum

2015)

The FED believes

the economy is

strong enough, and

the change will

facilitate the

recovery from the

crisis (Gillespie

2015)

Janet Yellen announced that the Fed will raise the

rate, depending on the economic growth

(Applebaum 2015). The change in the rate will be

small, but it will affect a lot of people. Savers will

get more interest on their savings and mortgages

rates will slowly increase. Therefore, there is going

to be an increase in deposits in banks also an

increase in capital inflow from the foreign investors.

Thus, USD will appreciate.

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On the 3rd

quarter

GDP growth beat

the economist

forecast (Heath

2015)

Fastest earning in

exports since 2000

and supporting the

decision of keeping

interest rates steady.

The GDP of Australia has increased more than

forecasted because the export has surged, which is

the largest hike since the equivalent quarter of 2000.

This tells us that there is an increase in productivity,

because Australia has to export all those goods,

which will make general price level in the economy

down (Heath 2015). This will cause inflation to

decrease and the AUD will appreciate.

US current account

deficit reaches

highest level since

2008 (Bartash

2015)

The deficit increase

was mainly because

of the higher

payments to

foreigners on US

investments and

income transfer.

USA’s debt to other countries rose causing an

increase to the current account deficit. Meanwhile,

the change in trade deficit was little. So, it infers

that USA needs more foreign currency than what

they get from their exports and they supply more of

its dollars than the amount foreigner demand.

Therefore, this will cause the USD to depreciate.

Iron ore drops to

10-year low (Ong

2015)

World steel

production remains

negative (Ray 2015)

Australia iron ore price has decreased since China

steel production has fallen while China is one of the

biggest iron ore importers. Moreover, since the

Aussie dollar is positively correlated with iron ore,

its dollar will move with the change in the price of

the commodity. Thus, the AUD will depreciate.

→ According to the qualitative analysis, Australian dollar will be expected to depreciate in December.

V. Limitations

This report has figured some limitations regarding the use of single equation model:

‘Black box’ problem – the regression is run entirely on the regression technique; however, under the

mechanism, we do not know how it is processed and whether it is correct or not.

Data frequency- the data is not consistent as Australia’s data published is quarterly data while the USA is

monthly. Hence, we have to collect data from numerous sources and it may cause data inconsistency.

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Multicollinearity – there could be a negative effect on the result of the regression as determined variables

are interrelated to each other, for example money supply and interest rate or growth rate and inflation.

Hence, predicted exchange rate may be less accurate.

Due to its limitations, this report will forecast the future exchange rate by conducting the qualitative

analysis via economic news and global events in 2015 to adjust the exchange rate.

VI. Forecast the exchange rate (See appendix)

On 30th November, the actual . Based on the regression, the report has calculated the

exchange rate on 1st December 2015 and compared with the actual exchange rate in the following table:

Model PPP model UIP model Backward

Elimination model

Actual

% 0.002975% -0.00034% -0.0076% 0%

Exchange rate 0.72332 0.7230 0.72325 0.7233

As can be seen from table above, the PPP model will give the best result which is the closest to the actual

exchange rate on 1st December 2015.

VII. Conclusion

Although, our forecast above indicates that PPP model have the best result in forecasting exchange rate,

this report will decide Backward Elimination model which is considered the most accurate model in

forecasting the exchange rate. The reason is that Backward Elimination model includes many significant

variables with lowest p-value, while PPP model only has one variable and one time it has the closest to

the actual exchange rate may not considered as the best model. Thus, based on Backward Elimination

model, the exchange rate will increase. Therefore, USD will appreciate and invest in USD will benefit for

traders.

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VIII. Appendix

1. Methodology

The report conducts two approach methods: quantitative analysis and qualitative analysis.

The quantitative analysis will use the monthly data of the macro-economic variables from Reserve Bank

of Australia, Data360, Trading Economics and IMF e-Library. By the collected data, the regression will

run through these variables to see which variables are significant to predict the exchange rate.

The qualitative approach uses the availability of the information such as news, press release, government

intervention, etc. to predict the direction of the exchange rate. This approach will expect to be

supplementary for the fundamental analysis which may occur the statistical meaning than economic

meaning.

2. Money supply definition

M1 in Australia:

According to Australian Bureau of Statistics (2012), M1 is defined as currency plus current deposits

from household. As M1 contains cash and assets, hence M1 is very liquid to measure the Money

supply.

M2 in the US:

The Federal Reserve Bank defined M2: savings deposits plus M1, deposits of less than $100,000 and

balances in the money market.

M1: is the total amount of currency which is held by the public and transactions deposit at

depository institution (including saving banks, credit unions, commercial banks and loan

associations)

3. Exchange rate formula:

⇒

4. Calculation for exchange rate:

On the 1st December 2015, we have the following information:

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USA Australia

Inflation 0.5% 1.5%

Nominal interest rate 0.25% 2%

Money supply (M2 in US only) 12288 million on 1st December and 12237.8 million in 30

th

November

time series 240

Unemployment rate 5% 5.8%

4.1 PPP model:

%

→ S= = 0.72332

4.2 UIP model

%

→ S= = 0.72330

4.3 Backward elimination model

% 0.0231-0.3542*(0.5%-1.5%)+0.3683*(5%-5.8%)-1.7769*ln(12288/12237.8)-

0.0001*240 = -0.0076%

→ S= =0.72325

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5. Purchasing Power Parity (PPP)

6. Uncovered Interest Rate (UIP)

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7. Original model

8. Backward model

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IX. Reference

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