A comparative table of the real interest rates:
4. Under what circumstances should BID expect to prefer borrowing in one currency rather than the other?
Borrowing in different currencies offsets the losses if occur due to unanticipated change of events in the markets.
BID must maintain, monitor and control the data of most favourable currencies and a consistent analysis should be in place as a part of the system.
BID can also consider the forward parity for decision making since the analysis of historical data clearly illustrates that there exists very little deviation and hence the future spots rates can be predicted on basis of the forward rates. In case one currency depicts positive and consistent trend, BID can base its borrowing on one particular currency.
It can also take some extra measures to avoid currency risk through Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk
5. Consider the various international parity conditions. During 1996-2005, how well did these conditions describe:
- The relationship between forward and spot exchange rates?
According to the forward parity theory we know that future spot prices could be very well precisely predicted by the forward rates therefore, we find from the graph that the deviations are small and of the type 0.0xx. Hence we can say that the data between 96-05 follows the FP.
- The relationship between exchange rates and inflation rates?
As per PPP, spot exchange rates of currencies will change to the inflation rate differential.
As per the graph 5b, a conjoined pattern with no different boundaries. Here it seems that the inflation rates are a good indicative of the spot rates. Therefore, this could be helpful in the analysis for BID since if the prediction of one is done fairly accurate then the other would obviously follow suit and hence BID could hedge risks and could cut some costs.
- The relationship between interest rates and exchange rates?
According to the Interest Rate Parity Theory, The forward premium or discount equals the interest rate differential.
(F - S)/S = (rh - rf) i.e premium/discount equals the interest rate differential
As we already saw as a part of analysis that the deviation from IRP is of the order 0.00xx there we can say that IRP theory holds true and the historical data is in coherence with the theory
The above deductions also show that we can take strategic decisions based on various relationships and hedge risks while transacting between two countries with different currencies.
6. How does the performance of the parity conditions affect the effective borrowing costs faced by BID?
Forward Parity: Deviation from FP, Mean= 0.0452. This shows that the Fp holds true since there is a small deviation from it.
Interest rate parity: Deviation from IRP, Mean= -0.0004. This could almost be estimated as zero and hence a perfect IRP holds.
PPP: Deviation from PPP, Mean= 0.0012, This also indicates the PPP holds true.
Since BID borrowed hugely from USA which was at a higher interest rates as compared to other currencies and these parity conditions indicated positive outcomes therefore BID costs might have been high at some point during the tenure where it could have easily avoided the same by switching to another currency with lower rate of interest.
Therefore this is obvious that if BID performs these analysis in future it can easily avoid many of the costs.
ANALYZES
REAL INTEREST RATES
To understand the differences between US and Japanese rates, you will need to manipulate the historical data to determine real rates. First you need to calculate real interest rates for Japan. In column K and L.
In column M, calculate the difference in interest rates by subtracting the real U.S. rates from the real Japanese rates. What conclusions can be made about the relationship between real Japanese and real U.S. rates?
Also if we check the difference in interest rate graphs we find the sharp positive peaks between 96 and mid of 2001 which are indicative of the fact that on an average interest rates were high in Japan hence if the bank borrows, it would incur greater costs. Optimal decision should be to borrow from US. However from mid 2001 onwards we find more negative sharp peaks of interest rates that indicate a change in trend and it somehow follows the same pattern until 2005. This shows that borrowings from Japan could be a better option from 2001 onwards since the lower Japanese interest rates might help in offsetting the infrequent rise during the same period.
Try building some of your own graphs. If your X-axis is cluttered with the dates, use <Options> <Scale> <Skip> and enter a skip factor of 24.
Using 123's @ functions, compute the mean and standard deviation for the real interest rate differences. What observations can you make from this analysis?
Summary Statistics for Real Interest Rate Diff
Count = 118
Average = -0.00259576
Variance = 0.000130108
Standard deviation = 0.0114065
Minimum = -0.0345
Maximum = 0.0227
Range = 0.0572
Stnd. skewness = 0.030429
Stnd. kurtosis = -0.17289
As we find that the standard skewness and kurtosis is within the -2 and +2 which are indicative of the real interest rate differences being a normal distribution.
Goodness-of-Fit Tests for Real Interest Rate Diff verifies further whether if it fits the normal distribution:
Chi-Square Test
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Lower Upper Observed Expected
Limit Limit Frequency Frequency Chi-Square
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at or below -0.0188623 9 9.08 0.00
-0.0188623 -0.0142313 8 9.08 0.13
-0.0142313 -0.0109946 8 9.08 0.13
-0.0109946 -0.00832642 13 9.08 1.70
-0.00832642 -0.00594223 10 9.08 0.09
-0.00594223 -0.00369717 9 9.08 0.00
-0.00369717 -0.00149435 7 9.08 0.48
-0.00149435 0.000750704 9 9.08 0.00
0.000750704 0.0031349 10 9.08 0.09
0.0031349 0.00580303 12 9.08 0.94
0.00580303 0.00903974 5 9.08 1.83
0.00903974 0.0136708 9 9.08 0.00
above 0.0136708 9 9.08 0.00
Verification of the same by an easy visual option can be through the below histograms
We can say that the real interest rate differences are normal and the small standard deviation of 0.0114065 tells that most of the interest rate values are close to the mean i.e. -0.00259576 or -0.2595%.
FORWARD PARITY (FP)
Next, examine the forward parity condition of exchange rates. First, calculate the natural log of the spot rate and 90 day forward rates in columns N and O respectively. To do this, use the @LN(x) function, where x is the spot rate. Then, in column P, calculate the deviation from forward rate parity. To do this, simply subtract n-log spot rate three months forward from n-log 90 day forward rate in the current month. The formula should be +O11-N14.
Based on your analysis, how well does the forward exchange rate predict the future spot rate 90 days later? Look at the graph 5-DEV-FP to support your conclusion.
Since we know that the forward parity states that the forward rate is an unbiased indicator of the future spot exchange rate and according to the graph this is quite obvious since deviations are small and of the type 0.0xx.
The mean of the deviation is a small of -0.0019 which could be approximated to 0.0 for the purpose of ease. Hence we can say that the data is accurate up to a greater extend and one can take good spot decisions looking at the forward exchange rates. However we find that in few months the deviation is of the type 0.1xx but this could be assumed as the uncontrolled component that the markets offer with time and not everything could be predicted.
INTEREST RATE PARITY (IRP)
Interest rate parity says that the difference between nominal yen and dollar interest rates is equal to the forward exchange rate premium or discount between the yen and the dollar.
To examine interest rate parity, first calculate the nominal interest rate differential in column Q by subtracting the 90 day Eurodollar rate from the 90 day Euroyen rate. Build a graph to illustrate IRP.
Finally, in column R, calculate the difference by subtracting the nominal rate from the forward premium. To compare this with the forward exchange rate premium, look at the graph named
6-INT-PARITY.
PURCHASING POWER PARITY (PPP)
Purchasing power parity says that the rate of exchange between two currencies should equal the difference in inflation rates between the two economies in question. If PPP holds, the following formula for deviations from PPP should equal zero:
(Japan CPI)-(US CPI)-(N Log Spot 3 Months Out - N-Log Spot Current)
Inflation rate of Japan shows sharp peaks ( up and down) indicative of inconsistency in the inflation rates and thus we can say that the economy experienced sharp rise n dip and hence the consumer purchasing power kept changing throughout the duration.
Inflation rates in US though not ideally consistent however experienced a comparative consistent trend and there were no sharp negative dips whatsoever.
Therefore we can say that spot exchange rates did not ideally change for Japanese Yen and US dollars in accordance with the change in their inflation rates. The two very different kinds of economies thus do not show a PPP and the same is evident from the graphs with positive –negative waves as well.
Questions from the case:
It was in these circumstances that Maria Méndez was asked to address the question of whether real capital costs had been lower in some currencies than others during the previous decade.
Whether there appeared to have been timing opportunities such as the treasurer had recently tried to exploit.
She wondered under what circumstances she should expect the bank to prefer to borrow in one currency rather than another.
Moreover, if a particular currency did appear to be cheaper at a given time, could the opportunity have been exploited without hindsight? If so, how?
Finally, how long might such an opportunity persist? The results of the analysis would affect not only the choice of currency for the bank’s next issue, but also the larger debate about the bank’s borrowing strategy.
First, as to avoid further criticism it must stick to the company strategy and decide to base its decisions either by monitoring the time or taking into greater consideration the internal targets. This would help build a stronger base for the Bank and also to analyze any discrepancies that might occur in future.
Implications: Currency with the lower interest rate expected to appreciate relative to one with a higher rate.
References:
