1. 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
2. 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
3. 1 | P a g e
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.
4. 2 | P a g e
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
5. 3 | P a g e
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
6. 4 | P a g e
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 = (Ee
USD/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.
7. 5 | P a g e
The equation implies that the percentage change in the exchange rate will decrease 18.62% or each unit
increases in nominal interest rate differential.
8. 6 | P a g e
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.
9. 7 | P a g e
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:
10. 8 | P a g e
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.
11. 9 | P a g e
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.
12. 10 | P a g e
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.
13. 11 | P a g e
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.
14. 12 | P a g e
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:
15. 13 | P a g e
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 30th
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
16. 14 | P a g e
5. Purchasing Power Parity (PPP)
6. Uncovered Interest Rate (UIP)
17. 15 | P a g e
7. Original model
8. Backward model
18. 16 | P a g e
IX. Reference
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19. 17 | P a g e
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