EFN426 Applied Research in Finance Assignment

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Reference no: EM132640057 , Length: 10 pages

EFN426 Applied Research in Finance - Queensland University of Technology

This research problem examines spot GBP/AUD exchange rates and predictions of the exchange rates. This task is based on an international parity condition called the Fisher open hypothesis. Under this hypothesis, the expected movement in spot rates is a function of interest rate differentials.

Suppose
rt,AU represents the Australian interest rate at time ???? for next 12 periods (months),
rt,AU represents the UK interest rate at time ???? for the next 12 periods (months),
St represents the price of AUD denoted in GBP at time t,
E[St+12] represents the expected exchange rate at time t + 12. The Fisher open hypothesis takes the form

E[St+12] = Stt × 1+rt,uk/1+rt.AU (1)

Optimally, the Fisher open hypothesis would provide an unbiased estimator for the spot exchange rate a year in the future. In other words, any rate of return differential between similar bonds denoted in the two currencies should be offset by the expected change in the exchange rate. In log- form, the above equation becomes

E[St+12] = st + rt,UK - rt,AU(2)

For (2) to be an unbiased estimator for the future spot exchange rate,

St+12 - E[st+12]

where ut is White Noise. Rewriting (3),

(St+12 - St) - (rt,UK - rt,AU)

provides the interpretation of the change in log exchange rate and the interest rate differential sharing a long run equilibrium.

PART I

Test if the Fisher open hypothesis holds.

PART II

Looking at equation (4), note that the claimed equilibrium should exist between the rate differential (known at time t) and the change in exchange rates (known a year later). For more contemporaneous relationship analysis, consider the difference in expected and realized spot exchange rate st - E[st], and the rate differential rt,Au- rt,A, both measured at time t. Carry out a full analysis on the short and long run dynamics, looking at the two series individually, and examining the interaction between the two.

Attachment:- Fisher Open Hypothesis.rar

Reference no: EM132640057

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