Effect of the exchange rates and inflation on the investment - Statistics Project Example

Effect of the exchange rates and inflation on the investment Introduction The major objective of this project is to make use of relative form of Purchasing Power Parity (PPP) in acknowledging whether the prices levels of any fixed basket of products are equal to the Exchange Rate between UK and US. In this case, PPP proposes that there is achievement of equilibrium in the exchange rates between these two countries’ currencies given that the purchasing power is common. Naturally, the two territories have different prices due to the difference inflation rates thereby calling for rejection of absolute form and the subsequent use of relative form of PPP. Further, the use of PPP will help in determining the effect of inflation rates on exchange rates in each of the two countries. The knowledge about the inflation rate will conclusively lead to comparison of the intensity of investment between the countries. Accessing the relationship between exchange rates, interest rates and inflation is essential in understanding the intensity of investment. The necessity of PPP theory in this project arises because it acknowledges the changing patterns of trade usually witnessed between two countries as the result of the difference in inflation rates. In order to achieve the objective of the project, the baseline is to analyse the change of exchange rates between UK and USA through testing the PPP theory. Data given for the quarter period will be used in performing regression in Minitab thereby giving information on the differences about the exchange rates. Intuitively, the basis of this project is that absolute form of PPP cannot be used because it does not acknowledge the differences in prices thereby calling for the use of relative form. Test design The project involves testing the relevance of PPP theory through a real life situation comparison of the exchange rate and inflation rate between UK (pound) and US (dollar) for the period of 10 years quarterly (from 2000 to 2009). Success in carrying out this test calls for perusing through the EIU database. In this case, US and UK were selected as the subjects for comparison followed by acknowledging the period of time as from 2000 to 2009. US (av)-XRPD BGL/USD and GBP/USD were selected in the series section as the exchange rate LCU to help in getting the exchange rates, fiscal and monetary indicators. The quarterly data obtained from the table were exported to excel to help in carrying the test analysis. Further, the inflation rates were identified for the two countries by making use of the customer price indices (av)-LCPI instead of the LCU used for the exchange rate. After acquiring the data, the cross exchange rate BGL/GBP was determined through the help of the following formula Whereby CER is the exchange rate, ER is the exchange rate, and t is Time Further, the following formula was used in calculating inflation rate of UK and US Whereby Infl – Inflation Rate CPI – Consumer Price Index t – Time i.e. quarterly The difference of percentage change was determined by substracting the foreign country’s (US) inflation rate from home country’s (UK). Whereby ef – Change in the Relationship between relative Inflation Rates Inflh – Home Country’s Inflation Rate (UK) Inflf – Foreign Country’s Inflation Rate (US) ≈ – symbol used for the approximate approach After using the above formulas the following table was obtained for 2009.   BG GB BGL : Ј1 Change In The United Kingdom UK inflation US Inflation US Inflation InflUK-InfUS (ef) ef Unit BGL/USD GBP/USD BGL/GBP Exchange Rates CPI (av) % CPI (av) % % positive/negative 2009_I 1.4697 0.699301 2.101670096 0.036278032 109.3670 -0.3944 6014.600 -0.3944 0.0 positive 2009_II 1.3838 0.607829 2.276627143 0.083246675 110.6000 1.1274 6029.567 0.2488 0.8786 positive 2009_III 1.3357 0.624844 2.137653558 -0.06104363 111.2670 0.6031 5965.867 -1.0565 1.6595 positive 2009_IV n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. The rest of the data for the year 2000 to 2008 are presented in the appendix Test Results Regression analysis for Change in The Exchange Rate Versus US inflation for the 10 years The regression equation is change In The Exchange Rates = - 0.0109 + 0.0025 US inflation Predictor Coef Se Coef T P Constant -0.01238 0.02015 -2.11 0.173 UK inflation 0.00254 0.01122 -0.17 0.856 s - 0.0463921 R-Sq = 0.14 R-Sq (adj) = 0.04 Analysis of Variance Source DF SS MS F P Regression 1 0.00008 0.0000123 0.06 0.857 Residual Error 36 0.077462 0.002152 Total 37 0.07753 Unusual Observations Obs UK inflation Change In The Exchange Rates Fit SE Fit Residual St Resid 33 2.01 0.00565 0.00596 0.02227 0.01161 0.29 35 0.09 -0.16694 -0.01097 0.00911 -0.15597 -3.43R 37 1.24 0.08325 -0.0081 0.01258 0.0925 2.05R The regression equation is “change In The Exchange Rates = - 0.0109 + 0.0025 US inflation”. An especially high P value of 0.857 = 85.7% results from the probability coefficient of 0.0254. There are only -0.17 standard errors, an indicator that the model is less than 95% confidence interval. As indicated the standard deviation is "0.0463921 and the "R-Sq" 14%. From this the "R-Sq (adj)" = 0.4% implies that the model does not fit at all in the ‘Change In The Exchange Rates versus US Inflation’ as shown in the following scatterplot. Regression analysis for Change in The Exchange Rate Versus US inflation for the 10 years The regression equation is change In The Exchange Rates = - 0.0113 + 0.0027 UK inflation Predictor Coef Se Coef T P Constant -0.01129 0.01015 -1.11 0.273 UK inflation 0.00265 0.01382 0.19 0.849 s - 0.0463833 R-Sq = 0.14 R-Sq (adj) = 0.04 Analysis of Variance Source DF SS MS F P Regression 1 0.000079 0.000079 0.04 0.849 Residual Error 36 0.077451 0.002151 Total 37 0.07753 Unusual Observations Obs UK inflation Change In The Exchange Rates Fit SE Fit Residual St Resid 33 2.01 0.00565 0.00596 0.02227 0.01161 0.29 35 0.12 -0.16694 -0.01097 0.00911 -0.15597 -3.43R 37 1.13 0.08325 -0.0083 0.01156 0.09155 2.04R The regression equation is “change In The Exchange Rates = - 0.0113 + 0.0027 UK inflation”. High value of 0.849 = 84.9% is realized for the probability of coefficient of 0.0265. There are only -0.23 standard errors, which mean that it is less than 95% confidence interval. The value for "S" 0.0463729 provides the estimate for the standard deviation, and the "R-Sq" 0.14 (14%) is the indicator of how the model fits the data. This result to a "R-Sq (adj)" of 0.0% consequently the model does not fit the data. Figure showing a scatterplot constructed for change in the Exchange Rates vs UK inflation The statistical model was crucial in constructing a straight-line predictor in which case the change In The Exchange Rates = - 0.0113 + 0.0027 UK inflation represents the regression line about which all values for change In The Exchange Rates and UK inflation fall. As can be noted from the scatterplot chart UK inflation is stable since percentage change fluctuates from -0.5 to 2.0 and the trend increases. Regression analysis for Change in the exchange rates vs infUK-infUS was created to show the percentage change and the trend line for 10 years The regression equation is change In The Exchange Rates = - 0.0124 + 0.0032 0032 inflUK-inflUS Predictor Coef Se Coef T P Constant -0.01129 0.01015 -1.11 0.273 UK inflation 0.00270 0.01382 0.19 0.849 s - 0.0463833 R-Sq = 0.6 R-Sq (adj) = 0.04 Analysis of Variance Source DF SS MS F P Regression 1 0.000079 0.000079 0.04 0.98 Residual Error 36 0.077451 0.002151 Total 37 0.07753 Unusual Observations Obs UK inflation Change In The Exchange Rates Fit SE Fit Residual St Resid 33 2.01 0.00565 0.00596 0.02227 0.01161 0.29 35 0.12 -0.16694 -0.01097 0.00911 -0.15597 -3.43R 37 1.13 0.08325 -0.0083 0.01156 0.09155 2.04R The regression equation is change In The Exchange Rates = - 0.0124 + 0.0032 inflUK-inflUS. The probability that the coefficient is 0.00270 points to a relatively higher value of 0.98= 98.0%. There are only 0.26 standard errors, which mean that it is more than 95% confidence interval. The standard deviation "S" 0.0463633 shows the actual deviation from the mean, and the "R-Sq" 0.6 (60%) depicts how the model fits the data therein. This confirms that the overall model slightly fits in the data for ‘Change In The Exchange Rates versus InflUK-InflUS’ as shown in the following scatterplot. The actual values of the change in the exchange rate are relatively on closer distance to the assumed regression line. Further, the R-square is also closer to 1 showing there is no significance difference. As can be shown, more values are fitted within the regression line and there are also less residuals. The model Home Inflation – Foreign Inflation is not that constant as can be shown by the variation from -5 to 3. However, there is increasing trend.. Reflection on the results According to the tested results UK inflation is slightly higher than the foreign inflation in US. Consequently, this explains the fact that the buyer’s power in US is greater than that in the UK. In case of investment, an investor should consider putting his project in US because of the assurance of higher capacity buying. The results showing the relationship between relative inflation rates and the exchange rates, depicts that there are more positive outcomes than the negative outcomes. Consequently, the two countries have less to do with influencing each other’s currency. In this case, whenever US inflation becomes less than UK inflation, there would be less evidence of the depreciation in the dollar. This implies that the foreign currency should remain relatively constant when the US inflation becomes less that of UK. Intuitively, this means that the prices would remain constant unaffected by the mutual inflation shared by the two. As shown in the relatively lower inflation witnessed by US, investors will consider the foreign country as best for investment since it an upward pressure on the prices in UK (Gerolamo, 2009, 34). According to the definition of inflation, this is true since a higher value indicates uncertainty about future prices and exchange rates; consequently, scaring away the investors. The relatively higher inflation in UK shows that less investor will be willing to put up their projects as compared to US. However, the regression analysis table shows that the two countries are almost equal to each in terms as depicted in the regression witnessed by both. Further, the scatterplot of change in The Exchange Conclusively, it would be right to say that between any two countries difference in inflation and the interest rates can influence the choice of an investor. Using the relative form of PPP theory was essential in comparing the two countries even in the presence of difference in prevailing prices and interest rates between the two. Bibliography Fox R., Madura J., International Financial Management, Thomson Learning, London, 2007 Gerolamo D., Inflation and Its Effects on Investment. 2009, Available at: http://www.bu.edu/econ/faculty/kyn/Ec341_money/Papers/Gerolamo_paper.htm Appendix BG GB BGL : Ј1 Change In The United Kingdom UK Inflation US Inflation US Inflation InflUK-InfUS (ef) ef Unit BGL/USD GBP/USD BGL/GBP Exchange Rates CPI (av) % CPI (av) % % positive/negative 2000_I 2.0474 0.628062 3.259869249   92.3670 x 3366.767 x x x 2000_II 2.0467 0.660939 3.096654911 -0.050067756 93.1330 0.8293 3342.867 -0.7099 1.5392 positive 2000_III 2.2314 0.67627 3.299569698 0.065527091 93.0670 -0.0709 3463.400 0.0057 0.0733 positive 2000_IV 2.1019 0.668673 3.143389968 -0.047333363 93.6330 0.6082 3615.367 0.6082 1.2164 positive 2001_I 2.2145 0.704722 3.142373872 -0.000323248 93.1330 -0.5340 3666.100 1.4033 -1.9373 negative 2001_II 2.3064 0.710379 3.246717597 0.033205382 94.5330 1.5032 3665.200 -0.0245 1.5278 positive 2001_III 2.142 0.680689 3.146811539 -0.030771404 94.5000 -0.0349 3680.100 0.4065 -0.4414 negative 2001_IV 2.2193 0.687616 3.227528155 0.025650286 94.6330 0.1407 3792.000 3.0407 -2.8999 negative 2002_I 2.2419 0.701754 3.194709257 -0.010168431 94.6000 -0.0349 3965.700 4.5807 -4.6156 negative 2002_II 1.9607 0.655953 2.989086108 -0.06436365 95.4330 0.8805 3925.600 -1.0112 1.8917 positive 2002_III 1.9836 0.636943 3.114250412 0.04187377 95.4670 0.0356 3851.000 -1.9003 1.9360 positive 2002_IV 1.885 0.621311 3.033907335 -0.025798528 96.0330 0.5929 3921.167 1.8220 1.2292 positive 2003_I 1.7952 0.633312 2.834621798 -0.065686099 96.0000 -0.0344 3989.700 1.7478 1.7821 positive 2003_II 1.71159 0.604997 2.829088409 -0.001952073 96.6330 0.6594 3967.800 -0.5489 1.2083 positive 2003_III 1.6785 0.601685 2.789665689 -0.013934778 96.8000 0.1728 3968.700 0.0227 0.1501 positive 2003_IV 1.5486 0.560475 2.763013515 -0.009553895 97.3000 0.5165 4105.133 3.4377 -2.9212 negative 2004_I 1.6 0.543478 2.944001413 0.065503805 97.2000 -0.1028 4244.700 3.3998 -3.5026 negative 2004_II 1.6091 0.551694 2.916653072 -0.009289514 98.0000 0.8230 4235.300 -0.2215 1.0445 positive 2004_III 1.5761 0.552792 2.851162824 -0.022453904 98.0330 0.0337 4236.967 0.0394 -0.0057 negative 2004_IV 1.4359 0.521921 2.75118265 -0.035066455 98.7000 0.6804 4299.867 1.4846 -0.8042 negative 2005_I 1.5087 0.529437 2.849630834 0.035783951 98.9000 0.2026 4407.067 2.4931 -2.2905 negative 2005_II 1.6175 0.557724 2.900180017 0.017738853 99.9000 1.0111 4443.233 0.8206 0.1905 positive 2005_III 1.6242 0.565099 2.874186647 -0.008962675 100.3670 0.4675 4439.267 -0.0893 0.5567 positive 2005_IV 1.6579 0.581801 2.849599777 -0.008554375 100.8000 0.4314 4584.767 3.2776 -2.8462 negative 2006_I 1.6159 0.574944 2.810534591 -0.013709008 100.8330 0.0327 4760.433 3.8315 -3.7988 negative 2006_II 1.5385 0.540804 2.844838426 0.012205448 102.1330 1.2893 4811.100 1.0643 0.2249 positive 2006_III 1.5449 0.534302 2.891435929 0.016379666 102.8000 0.6531 4735.633 -1.5686 2.2217 positive 2006_IV 1.4851 0.510569 2.90871557 0.005976145 103.5330 0.7130 4865.100 2.7339 -2.0209 negative 2007_I 1.4686 0.508001 2.890939191 -0.006111419 103.7000 0.1613 5009.500 2.9681 -2.8068 negative 2007_II 1.4482 0.49843 2.905523343 0.00504478 104.7670 1.0289 5036.300 0.5350 0.4939 positive 2007_III 1.3794 0.490461 2.812456036 -0.032031168 104.6330 -0.1279 5265.400 4.5490 4.6769 positive 2007_IV 1.3312 0.503956 2.641500448 -0.060785159 105.7000 1.0198 5472.033 3.9244 -2.9046 negative 2008_I 1.2369 0.503651 2.455867257 -0.070275661 106.1670 0.4418 5674.867 3.7067 3.2649 positive 2008_II 1.2407 0.502361 2.469737898 0.00564796 108.3000 2.0091 5790.100 2.0306 -0.0215 negative 2008_III 1.3674 0.561672 2.434516942 -0.014261009 109.6670 1.2622 5906.233 2.0057 -0.7435 negative 2008_IV 1.3873 0.684041 2.028094807 -0.166941592 109.8000 0.1213 5978.467 1.2230 -1.1017 negative 2009_I 1.4697 0.699301 2.101670096 0.036278032 109.3670 -0.3944 6014.600 0.6044 -0.9987 negative 2009_II 1.3838 0.607829 2.276627143 0.083246675 110.6000 1.1274 6029.567 0.2488 0.8786 positive 2009_III 1.3357 0.624844 2.137653558 -0.06104363 111.2670 0.6031 5965.867 -1.0565 1.6595 positive 2009_IV n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 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