Currency Forecasting Project

Introduction

The foreign exchange rate is the rate at which one currency is traded for another. Due to its high flexibility, a number of investors or investment banks will make profit from arbitrage. The purpose of this project is to forecast what the exchange rates (USD/AUD, EUR/AUD and GBP/AUD) are going to be on 14th September 2016, and dividing AUD$100 million into the three currencies to profit from the forecast. This report is based on 3 different methodologies to predict these rates, namely, relative purchasing power parity, international fisher effect and forward rate.

Absolute Purchasing Power Parity

In Purchasing Power Parity (PPP) absolute version, it is stated that the movement of exchange rate can be offset by any inflation between countries.

The equation of relative PPP is given by:

Countries | Current inflation rate | Expected inflation rate |

AUS | 1.5% | 2.5% 1 |

US | 0.2% | 1.75% (mean of 1.6 to 1.9) 2 |

Euro Zone | 0.2% | 1.2% 3 |

UK | 0.1% | 1.5% 4 |

Since this report is focused on forecasting the exchange rate for 2016, it is suggested that the expected inflation rate is used instead of current inflation rate for calculation.

The forecasted currencies calculation is as follows:

USD/AUD

SUS/At+1 = SUS/At * (1+πUS)/(1+πA)

= 0.75*1.0175/1.025

= US$ 0.74451/A

It is expected that the exchange rate for USD/AUD will be $0.74451 per Australian dollar. In other words, US dollar will appreciate for 0.737%.

EUR/AUD

SE/At+1 = SE/At * (1+πE)/(1+πA)

=0.71*1.012/1.025

=EUR€0.70100/A

For EUR/AUD, the expected exchange rate is €0.70100 per Australian dollar, which means that Euro will appreciate for 1.28%.

GBP/AUD

SG/At+1 = SG/At * (1+πG)/(1+πA)

=0.50*1.015/1.025

=GBP £ 0.49512/A

Therefore, it has been forecasted that the future spot rate is £ 0.49512 per Australian dollar and that means British Pound will appreciate for 0.99% in 2016.

The above calculations indicate that the countries with a higher...