Reference no: EM13318507

Exchange rate prediction

Tony is a venturesome engineer who is your close friend and also a poker buddy of yours. Tony and his partner Maureen have planned to travel around the world. While they were busy planning the details of the trip Tony had asked you to help out with preparing for the travel. When Tony heard that you had enrolled in an 'International Finance' course he suggested a bet on whether you would be able to guess the AUD/GBP exchange rate and the CAD/GBP exchange rate until Tony returns at the end of 2014. To win the bet Tony has offered prediction criteria you must meet in order to win the bet:

1. The prediction of the exchange rate starts from the first quarter of 2014 till the third quarter of 2014.

2. A total of three predictions should be made for the exchange rates for the last trading day of each quarter.

3. The prediction of the exchange rate must be made by using market data available one quarter (3 months) prior to the quarter you are trying to predict. For example, if you are predicting the exchange rate for the first quarter of 2014 you can only use data available until the last day of the previous quarter (fourth quarter of 2013).

4. You have to setup two prediction models. One of the models should use a regression analysis, whilst one of the models should be a time-series analysis model.

5. In the regression analysis, the inflation rate and the risk free interest rate (cash rate for AU, official bank rate for UK, target overnight rate for CA) for the three countries must be used to generate the independent variables. Additional independent variables are allowed with appropriate justification of the need for such variables.

6. The average estimation error must be less than 1% for both exchange rates for you to win the bet. (Note: whether you win or lose the bet is not assessed)

You decided that the bet with Tony was a good opportunity for you to try predicting the future exchange rates and implement an arbitrage or speculative strategy. At the end of the second quarter of 2014 (30 June 2014), you checked the current FX quotes for the spot and forward rates for the two exchange rates. The quotes were as below.
CAD/GBP AUD/GBP
30.Jun.2014 Bid Ask Bid Ask
Spot 1.8110 1.8310 1.7913 1.8313
1 Months Forward 8 9 35 36
2 Months Forward 17 18 67 68
3 Months Forward 24 26 100 101
6 Months Forward 45 48 193 196
1year Forward 63 73 348 356

After selecting one of the prediction models with the best fit, you decided that a thorough investigation to test the efficiency of the FX market can be conducted.

With your current credit rating you can borrow up to £ 1 million Pounds Sterling (GBP). The spread over the risk-free rates for each of the countries are as below.

Country AUD CAD GBP
Spread (Loan) 3.000% 2.000% 1.500%
Spread (Deposit) 2.500% 1.600% 1.250%
Required: Questions to answer

In your 2,000 word report you are to provide information of the following:

1. Explain the prediction model(s) you have established. Explain how you collected the data for the models and what issues you faced in selecting the data.

2. Provide three predictions for the AUD/GBP spot exchange rate and CAD/GBP spot exchange rate at the end of the first quarter of 2014, second quarter of 2014, and third quarter of 2014.

3. Compare your prediction with the actual AUD/GBP spot exchange rate and CAD/GBP spot rate (available from RBA or BOE).

4. Using the forward quotes on 30 June 2014, propose an arbitrage strategy in the FX market.

5. Using the forecasted spot exchange rate from your prediction model, propose a speculative strategy in the FX market?

6. Did you win the bet? Does a composite model improve the accuracy of the prediction? Reflect on your forecasting model by evaluating the performance of the prediction models.

7. Discuss the limitations of your prediction model when the models are to be used for forecasting the one month future AUD/GBP exchange rates on a weekly basis.