International finance

A. Learning outcomes covered
1. Critically discuss the relationship between exchange rates, interest rates, and prices using models of exchange rate determination.
2. Evaluate the determination of current account and international business co-movement.
3. Critically review the operation of the exchange rate systems.
4. Predict and critically assess the financial and macroeconomic impacts of exchange rate fluctuations and exchange rate policies.
B. Assessment
The assessment consists of two parts, namely empirical study and small essay. Each part accounts for 50% of the final mark of this module. The required word count is 4,000 words in total excluding tables and graphs. This represents 2,000 words in total for empirical study and 2,000 equivalent words for small essay. For each part of the assessment, a 10% on the word limit is acceptable.

Empirical Study:
Please choose ONE of the following questions for your empirical study and prepare a 2,000 word written report. You should submit your dataset and program (in hard copy and in a CD) with hard copy report for evaluation.

1. Test for Risk Premia in Foreign Exchange Markets :
FT.com (UK) reports spot and forward exchange rate of other currencies against US Dollar (USD). You can download these data from FT.com data archive: http://markets.ft.com/RESEARCH/Markets/Data-Archive.
Choose one out of 35 currencies (SDR not included) for your analysis. Use the data of last date for each month as monthly data, collect spot rate (denoted as St), 1-month forward rate (denoted as Ft), and 3-month forward rate (denoted as ) from July 2009 to April 2014. Make use of the STATA programs on the blackboard to prepare answer for the following questions:

a) Produce a graph of the USD/c exchange rate, where c denotes the currency you have chosen. Provide your comments on the graph. Any abnormal observations (outliers)? Double check with the FT.com data archive to make sure these abnormal observations are not due to the errors you made during the data collection process. If they are not error inputs, are there any unexpected events (news) associated with these observations?

b) Produce a graph for monthly forward discount and provide your comments, where and .

c) Produce a summary statistics table for the variables in your dataset.

d) Download the STATA program ‘ex_risk_premia.do’ from blackboard. Modify the program to run the following regressions:

Test for the existence of a risk premium on the 1-month horizon by including the lagged forward discount as a regressor:

Test for the existence of a risk premium on the 3-month horizon by including the 3-month forward discount, lagged three months, as a regressor:

where

e) Interpret your regression results. Do you find evidence for the presence of risk premia in foreign exchange market? Provide your comments on uncovered interest rate parity (UIP) and covered interest rate parity (CIP) base on your regression results.

2. Test for Long-run Purchasing Power Parity (PPP) :

Read Chapter 14 of the following textbook (essential reading of this module):

Robert C. Feenstra and Alan M. Taylor. International Economics. Worth Publishers: 2nd Revised edition, International Edition (13 April 2011). ISBN-10: 1429269030. ISBN-13: 978-1429269032.

Design a framework to test for absolute PPP and relative PPP following monetary approach. You should use both graphical illustration and econometric method. Provide your comment and interpretation on the evidence you find.

Data needed for this question can be found from UNCTAD Statistics website: http://unctad.org/en/pages/Statistics.aspx.

Your report should contain:

a) Theoretical justification of your framework.

b) Summary statistics of your dataset.

c) Empirical evidence followed by comment and interpretation.

Small Essay:
Please choose ONE of the following questions for your small essay and prepare a 2,000 word written report.

1. Read Chapter 20 of Feenstra and Taylor (2011) textbook and answer the following questions: Compare and contrast the following scenarios in terms of their costs and benefits.

a. The central bank uses sterilization bonds to obtain reserves.

b. The central bank follows a strict currency board system.

c. A country maintains a backing ratio that exceeds 100%.

d. The central bank bails out the banking system to avert a financial system crisis.

2. Consider the different interest rate parity conditions studied in Chapter 13 of Feenstra and Taylor (2011) textbook and answer the following questions. You should briefly summarize the interest rate parity conditions and their underlying logics and implications before you answer the following questions one by one.

a. Why might the exchange rate used in forward contracts differ from the current spot rate? Why might the forward rate differ from the future spot rate expected by investors? Explain.

b. Consider an US investor seeking to invest in France. Using the UIP condition (allowing for risk), illustrate in details how each of the following would affect the value of the euro and U. S. dollar.

(1) A decrease in U. S. interest rates.

(2) An increase in France’s interest rates.

(3) A decrease in the expected future exchange rate, Ee$/€

C. Guidance for the assessment
1. Please note that the final mark of the resit will be capped at 50.

2. Format

Cover page: Specify the title of your work and your name and student ID.
Word limit: As specified with 10% allowed. Greater or lesser amounts will normally have consequences for the marks received.
Referencing: Your work must be fully compliance with Harvard protocols. Your assessment should include detailed references to a variety of literature sources and a wide-ranging bibliography of academic aspects of international finance.
Font / Size: Arial 11 or Times New Roman 11.
Spacing / Sides: 1.0 / Single sided / single line spacing between two paragraphs.
Pagination required: Yes
Margins: At least 3.17 to left and right, and ‘justified’.

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