Interest Rates and Exchange Rate Changes in the US and Chile - Term Paper Example

Task: Finance Work sheet: Statistical Report Country CHILE Six-year time period 2001 2002 2003 2004 2005 2006 Geom. Avg Inflation Rate: US 2.8 1.6 2.3 2.7 3.4 3.2 2.665 Inflation rate: Chile 3.6 2.5 2.8 1.1 3 3.4 2.73 Interest Rate: US 3.7 1.7 1.2 1.6 3.5 5.2 2.807 Interest Rate: Chile 6.2 3.8 2.7 1.9 3.9 5.1 3.924 % Change in CD SR (IQ) 17.7 8.5 0.4 -11.8 -8.2 -5.3 -0.28 % Change in CD SR (DQ) -15.04 -7.834 -0.3984 13.38 8.932 5.597 0.2839 PPP Implifications: (Since the Inflation rate is lower in the US than in Chile, the US currency will appreciate against the Chilean currency) Annual Uncovered Rate for US {(1 - 0.1504)*(1 + 0.062)} - 1 = - 9.773 % Annual Uncovered Rate for CHILE {(1 + 0.177)*(1 + 0.037)} - 1 = 22.05 % Suggested Investment strategy based on IFE: (The investors should borrow in the US and invest in Chile) The % change in CD SR (Direct Quote) % change in CD SR (Direct Quote) for the year 2001 = {1/ (1 + % change in Indirect Quote for 2001)} – 1 = {1/ (1 + 0.177)} – 1 = - 15.04 %. % change in CD SR (Direct Quote) for the year 2002 = {1/ (1 + % change in Indirect Quote for 2002)} – 1 = {1/ (1 + 0.085)} – 1 = - 7.834 %. % change in CD SR (Direct Quote) for the year 2003 = {1/ (1 + % change in Indirect Quote for 2003)} – 1 = {1/ (1 + 0.004)} – 1 = - 0.3984 %. % change in CD SR (Direct Quote) for the year 2004 = {1/ (1 + % change in Indirect Quote for 2004)} – 1 = {1/ (1 – 0.118)} – 1 = 13.38 %. % change in CD SR (Direct Quote) for the year 2005 = {1/ (1 + % change in Indirect Quote for 2005)} – 1 = {1/ (1 – 0.082)} – 1 = 8.932 %. % change in CD SR (Direct Quote) for the year 2006 = {1/ (1 + % change in Indirect Quote for 2006)} – 1 = {1/ (1 – 0.053)} – 1 = 5.597 %. The Geometric means Geometric mean for Inflation rate: US = {(1 + 0.028) * (1 + 0.016) * (1 + 0.023) * (1 + 0.027) * (1 + 0.034) * (1 + 0.032)} ^ 1/6 – 1 = 1.170935939^1/6 – 1 = 2.665%. Geometric mean for Inflation rate: CHILE = {(1 + 0.036) * (1 + 0.025) * (1 + 0.028) * (1 + 0.011) * (1 + 0.03) * (1 + 0.034)} ^ 1/6 – 1 = 1.175399914^1/6 – 1 = 2.73 %. Geometric mean for Interest rate: US = {(1 + 0.037) * (1 + 0.017) * (1 + 0.012) * (1 + 0.016) * (1 + 0.035) * (1 + 0.052)} ^ 1/6 – 1 = 1.180674054^1/6 – 1 = 2.807 %. Geometric mean for Interest rate: CHILE = {(1 + 0.062) * (1 + 0.038) * (1 + 0.027) * (1 + 0.019) * (1 + 0.039) * (1 + 0.051)} ^ 1/6 – 1 = 1.259751144^1/6 – 1 = 3.924%. Geometric mean for % Change in CD SR (Indirect Quote) = {(1 + 0.177) * (1 + 0.085) * (1 + 0.004) * (1 - 0.118) * (1 - 0.082) * (1 - 0.053)} ^ 1/6 – 1 = 0.983107839^1/6 – 1 = - 0.28 %. Geometric mean for % Change in CD SR (Direct Quote) = {(1 – 0.1504) * (1 - 0.07834) * (1 - 0.003984) * (1 + 0.1338) * (1 + 0.08932) * (1 + 0.05597)} ^ 1/6 – 1 = 1.017157233^1/6 – 1 = 0.2839 %. Q1. During the assigned time period: US dollar appreciated / depreciated (choose one) in real terms against the currency of the foreign country. (1+ih) /(1+if)-1 = {(1.028)/(1.036)} - 1= - 0.7722%. The negative sign implies that the real value of the US currency appreciated against the Australian currency. Q2.During the assigned period, what was the average uncovered rate of return from the US viewpoint in the foreign country? Ruh= {(1+ % change in DQ) * (1+rf)} -1. Ruh = {(1 + 0.002839)(1 + 0.062)} – 1 = 6.502 %. Q3. During the assigned period, what was the average uncovered rate of return from the foreign countrys viewpoint? Ruf= (1+ % change in IQ) * (1+rh) -1. Rh = (1 – 0.0028) (1 + 0.037) – 1 = 3.40964 %. Q4. Based on your answers to questions 2 and 3, given perfect hindsight about interest rates and exchange rate changes during the assigned time period you should have borrowed in the US and invested in the foreign country (Chile). Since the interest rate is lower in the US that in Chile, the cost of funds (the interest on the borrowed amount) will be lower for funds borrowed in the US than for funds borrowed in Chile. Therefore, investors should take the advantage of the cheaper source of funds. On the other hand, investments should be made in Chile considering that the interest rate is higher than in the US. A high interest rate means high returns on investments. Therefore, based on the interest rate differences between the two countries, funds invested in Chile generate more returns than funds invested in the US. Since RUH is greater than RUF and the interest rate in Chile is greater than in the US, the investors should borrow in the US and invest in Australia. Q5. Assume that you could both borrow and invest at the average interest rates prevailing in the country and in the US during the assigned time period. Also assume that you have a line of credit for one million dollars in the US or an equivalent amount in the foreign country. Given perfect hindsight about interest rates and exchange rate changes, please calculate your total profit in dollars using uncovered interest arbitrage during the assigned time period if you followed the strategy chosen in Q4. Therefore, RuH – RuF = uncovered interest arbitrage. The total profit = (uncovered interest arbitrage * borrowed amount. Total profit = {(0.06502 – 0.0340964) * 1,000,000 = $ 30,923.6. Read More