Executive summary
Our corporate J was a large financial company in Australian doing foreign exchange business. For doing the gambling business we need to change money to US dollar and EURO. We started trading with an amount equivalent to $400 AUD. This was to be used in purchasing and thereafter selling of foreign currencies in accordance to the fluctuating rates and tap the difference to earn profit from it.
This led to an in depth analysis on the currencies we were to trade in and the economic implications to these given currencies that might lead to the fluctuating prices. We analyzed among other factors Exchange rate expectations, International speculation and investment, Commodity prices, Relative interest rates and Purchasing power parity and Relative inflation rates.
These factors were to influence our trade in the currencies. We invested the amount and traded as we thought best but ended up making a loss of $1,025,444. The net loss was due to some wrong decisions that were arrived at after an analysis of the above mentioned factors. (Barro 2008)
Introduction
Jupiters corporate j objectives
The objective is to figure out how to raise EUR 480m in addition to raising USD 200m for purchase of gaming equipment. This is only possible if we make right investment for purposes of future profits for the company. Analysis of the movement in the market was very critical before the market opened in order to come up with a trading strategy to make profits and knowing the right time to sell. (Blanchard 2008)
Market view
The inflation rate at this time is not very high and the purchasing power parity was generally average. However, the demand for the Great Britain pounds fell to a very low point (Mankiw 2006). This was due to the inflation experience in this Great Britain. The spot rate we were dealing with indicated an exchange rate of about 1.6130.
The selling and buying influenced the price leading to slight fluctuations depending on the commodity currency that the exchange rate would be conducted in. Generally, the prices of GBP reduced and were selling at a lower rate. The USD on the other hand performed better, while we started at $0 we ended up with $207,638,640. This is because of the high demand of the currency both as a commodity and terms currency.
It may be used to indicate that the American economy was doing well with the purchasing power at stable position. A similar scenario was reflected at the Euro, the demand for the currency was high and this lead to a high price giving us a good profit margin. Having started at £0, we ended up with $583,424,646 which is generally a good margin. A complete analysis of these transactions is provided below at the strategy employed section. (Beins 2004)
A high inflation rate in the commodity currency host country would lead to a fall for demand for the products produced in the host country leading to the lesser demand of the currency and the value of the same would fall. This lead us to taking serous considerations to the inflation rates of the commodity currency host countries in order to make informed decisions on how to trade on the same. (Mcneill 2009).
The factors that influence exchange that we considered included:
Ask and Bid/offer factors
Asking for a price of a given currency from a bank influences the success or failure of the exchange rate. When one rings a bank and asks for a quotation for a given currency and the bank agrees on a given quotation, the decision to buy the given amount of currency at that rate relies on the buyer in this case us. And as such, we were at liberty to choose where and at what price we would buy the currency.
For the bid/offer factor, the bank also aims at selling at the highest price and buy at the lowest price in order to have a bigger spread since the exchange market does not have discounts (Krugman 2009)
Relative economic growth rates
An increase in the economic growth rate of the commodity currency host country would lead to a higher demand in the commodity currency and hence higher prices. For instance, if the Australian economy was to increase at a higher rate than most of the world economies, it would mean that there would be a higher demand for the AUD currency to purchase the imports since there is a higher purchasing power among the Australians.
This leaves the market with less AUD and hence an increased demand for the AUD and a limited supply leading to the shift of the prices of the currency. The economic growth rate therefore informed an important part of our decision on whether and when to sell or not.
We took a research on the economic growth rate on host countries of the currencies we were to deal with. These included the United States of America, Australia, Great Britain and the European Union. (Cohen 2007)
Purchasing power parity and Relative inflation rates
A high inflation rate in the commodity currency host country would lead to a fall for demand for the products produced in the host country leading to the lesser demand of the currency and the value of the same would fall. This lead us to taking serous considerations to the inflation rates of the commodity currency host countries in order to make informed decisions on how to trade on the same. (Mcneill 2009)
Relative interest rates
This is formed our biggest mistake in the factors that we considered affecting the exchange rates. We assumed that a higher nominal rate would translate to higher investments into the country and therefore a rise in demand of the country’s currency value this should in turn lead to a rise in the value of the currency in question. However, the real situation is not as we thought. We ignored the fact that a country with a high interest rate would also have a higher inflation rate (Cohen 2007).
Australia cut the interest rate from 4.25 to 3.75. Once the interest rate decreased, the expert return is getting lower so that the demand of AUD is getting lower. This is because of the reasonable assumption that the real interest between countries is constant. The increase of nominal interest rate of Britain from 7.5% to 9% which attracted our interest and lead to believe that real interest had arisen.
But we ignored that inflation rate had risen from 4.5% to 6.2%. This meant that the inflation rate had really hampered the real interest rate which had reduced by 0.2%. It reasonable since if this were not the case, capital would flow to the country with high interest rates until the interest rates are constant in the world.
It is however important to realize that nominal rate is different from real interest rate. Since normal interest rates do not take into consideration the inflation rate in the given country’s when coming up with up with the rates while real interest rates do. i.e.
Real interest rate=Nominal interest-inflation rate
As such, considering only the nominal interest rate of a country and making trading conclusions about of it is dangerous. In our analysis of the various countries and their interest rates, we only considered the nominal interest rate and did not calculate the real interest which we were to consider in making decisions on the trade. (Mankiw 2006)
Commodity prices
An international change in the prices of a commodity would lead to a change in the demand of that commodity. If this commodity is an export of the given country, due to a higher inflation in that country, the prices of that commodity will rise in the international market which will eventually lead to a reduction in the demand for that commodity and as such reduce the demand for the commodity currency of the given host country. A reduction in the demand for the currency will also lead to a reduction in the price of that currency. This is a factor that we took into consideration while conducting our analysis. (Arnold 2010)
International speculation and investment
Global speculation influences the price of currencies as investments drive it. For instance, speculation on the default of the US economy has lead to the preference of the Australia as an alternative investment destination. This leads to a rise in the demand of the AUD and therefore a rise in the price of the currency. In however leads to a reduction in the price of USD as investors shift their focus to more friendly economies. (Krugman 2009)
Exchange rate expectations
Another very important factor we took into consideration was the exchange rate expectation. This has been known to influence the market a great deal. When investors expect the price of the currency to fall, they will sell the currency to avoid making loss of selling the currency later. This will increase the supply of the currency in the exchange market and hence reducing the price of the currency. The reverse is also true. (Barro 2008)
Trading strategy and performance analysis
Trading strategy
The following are the trading strategy we employed when trading in each of the currency traded. The factors considered and guided the trade are the speculation that was surrounding each of the currency, the economic situation of the commodity currency’s economy, interest rates economic growth rates and commodity prices in the given countries (Mcneill 2009). We embarked on the activity of getting to know who our sellers were and analyzing their offers against others.
We would also target the lowest offer by the banks and the RBA on the average prices of the currencies and identify the lowest bidders from which we would then buy from. Getting the lowest bidder in the market demands a very good knowledge on the sellers and their prices. Being the price takers, we would have to wait for the price of the currencies to be fixed and then identify who was selling at the lowest price. (Cohen 2007)
Performance Analysis
As a corporate, a price taker, we started with a good attitude from the market. Most of our clients were from our gambling games recommended us to other people, cooperate and banks. We went therefore to buy at the lowest prices offered price by the bank since we are a price taker and sell at the highest of prices to our clients.
We had a team of two people (Arnold 2010), one of us would be engaged in looking for buyers that we would sell the currencies to while the other would focus on looking for the lowest bidders to whom we would sell the currencies. The first thing we had to do was to analyze the factors that shape the prices of the currencies and speculate on most likely prices of the currencies.
We would then call banks and take the lowest prices they offered to us since we are a price taker. At the instance, the prices for the currencies exchange rates were standing at USD=1.0682 EUR= 0.8016 GBP= 1.6130. The USD increased to 1.1202 and the EUR was selling at 1.2101. This helped us gain profit as we called banks and they were really interested in buying at our price of 1.10 for the EUR and 1.0 for the USD.
We sold a considerable amount of the currencies and gained a total of about $791,063, 286. This boosted our earnings and motivated our trade. Due to the hype, we started selling the GBP even though their prices had fallen to 0.999. This was because of the increase of nominal interest rates of Britain from 7.5% to 9% which attracted our interest and lead to believe that real interest had arisen. But we ignored that inflation rate had risen from 4.5% to 6.2%.
This meant that the inflation rate had really hampered the real interest rate which had reduced by 0.2%. We speculated that their prices would go down further due to the rising inflation in Britain. We had to sell all of them at a loss of about 0.614 leading to a loss of -$651,452,711.
The next day it turned out that we were right as the prices of the GBP went on declining. We however learnt that before buying any of the currencies, it is important to keep sober and analyze all factors that might shape the shift of the prices in the future (Krugman 2009).
Lessons and Possible Improvements
The float of exchange rates are influenced by inflation rates a big deal. When inflation rate rises, prices of the commodities from the commodity currency country rise above the normal price prompting buyers of these commodities to shift and purchase such commodities from other competing countries which in turn reduces the demand for the currency. A reduction on the demand of the currency means a reduction in the price of that currency.
As such, we learnt that inflation is an integral part of that determines the prices of currency and should therefore be carefully considered. The demand and supply of the currency in the exchange market also shapes the price. When the RBA reduces supply of USD for instance in the market, the prices of the USD will rise due to the forces of demand and supply.
Forces of supply and demand are determined by the supply and demand of the same by the RBA. The RBA comes in as a player to regulate the prices of the currencies depending on the current rates. High exchange rates might lead to inflation in the country and therefore to protect the economy, the RBA comes in to buy or sell currencies in order to stabilize the prices (Barro 2008)
We learnt that it when trading nothing should be taken for granted and that every factor should be considered into the finest of details. One should not assume that member states of given unions have an identical economy to the union itself, e.g. one should never assume that the economy of Britain is performing similarly to the European Union economy simply because Britain is an active member of the union.
When considering the nominal rates, one should always subtract the inflation rate and remain with the real interest rate on which one should make their decision. The real interest rate should be the basis on which decisions are anchored (Blanchard 2008).
Conclusion
Even though we made good trades in most of the currencies we traded in, we made a mistake and placed a risk where we shouldn’t have leading to the loss we had. The Great Britain Pounds made us have a huge loss that could not be compensated by the profits we made from trading in the American Dollar, AUD and the Euro. (Trochim 2006)
References
Arnold, A 2010, Macroeconomics, Cengage Learning, Chicago.
Barro, R. J 2008, Macroeconomics: A Modern Approach, Cengage Learning, Chicago.
Beins, B 2004, Research Methods: a tool for life, Pearson/Allyn and Bacon, Michigan.
Blanchard, O 2008, Macroeconomics, Pearson Hall, Carlifonia.
Cohen, L 2007, Research Methods in Education, Routledge, Washington D.C.
Krugman, R. W 2009, Macroeconomics, Worth Publishers, New York.
Mankiw, G 2006, Macroeconomics, W H Freeman-Usa, New York.
Mcneill, P 2009, Research Methods: Third Edition. Cengage Learning, Chicago.
Trochim, W 2006, Research Methods Knowledge Base, Cengage, Chicago.