Exchange rates are a significant factor in determining a country's internal and external economic prospects. Exchange rates are crucial in the conduct of global economic operations such as import and export between countries (Gnimassoun, 2015). The report's content focuses on discussing the reasons for the AUD/USD exchange rate's volatility over the last five years. The long-term trajectory in the exchange rate, as well as the variables that influence it, have been thoroughly examined. Future exchange rates for the AUD/USD currency pair are analysed and explained, as well as real-world exchange rate data are tested for theories like as PPP, IRP, and IFE.
Data and Summary stats
For the purpose of analysis, the following variables will be employed to meet the project's aim. The AUD/USD spot rate for the last five years, the AUD/USD future rate, the US interest rate and inflation rate for the previous five years, and the Australia interest rate and inflation rate for the previous five years are among the factors. For the sake of simplicity, the terms forward rates and futures rates have been interchangeably used. The method of interpolation was employed to turn the quarterly inflation data from Australia into monthly data. The summary statistics of all the variables were displayed in the table below:
The futures exchange rate between AUD/USD has a mean lower than the spot AUD/USD exchange rate which is demonstrated in the graph below:
According to the mean value, the inflation rate in the United States has traditionally been higher than the inflation rate in Australia. Although, as the standard deviation of the Australian inflation rate suggests, the inflation rate in Australia has been more erratic.
The interest rate in Australia has historically been higher than the interest rate in the United States, as indicated by the average interest rate value over the previous five years, but less volatile than the interest rate in the United States. The mean interest rate of US and Australia are shared below:
The correlation matrix of all the variables is shared in the table below:
Behavior of exchange rate
The Australian currency rate is subject to a floating exchange rate regime, which means that its value is determined by market demand and supply factors (Rahman, 2018). Inflation rate, commodity prices in a nation, interest rate differentials with other countries, and economic policy framework are all elements that impact a country's exchange rate (Engel, 2016).
The Australian dollar has declined based on a trade weighted value since the conclusion of the mining boom in 2013. Following the subprime crisis, short-term rates throughout the world, particularly in the United States, fell to near zero to accommodate growth and avoid deflation (Kasahara, Sawada & Suzuki, 2016). On the other hand, the Australian Central Bank has kept the interest rate in the country on the higher side to attract investment in the form of foreign capital ultimately resulting in the better performance of AUD/USD in the recent years. Since the onset of the year 2015 due to the rise in the interest rate differential between the two countries, the Australian dollar has seen depreciation against the US dollar (Hsing, 2015). The historical gap between the interest rate between different countries is represented in the graph below:
Due to the progressive drop of Australian policy rates from 3 percent to 0.1 percent, the Australian dollar depreciated against the US dollar from June 2019 to June 2020, falling below the 0.7000 mark and approaching 0.6000 (Bui & Fisher, 2016). The AUD/USD exchange rate has dropped sharply since the commencement of the Covid-19 outbreak, owing to widespread forecasts of economic difficulties and decreased productivity. The currency rates have recovered in value after the initial assault of selling pressure, and have now returned to pre-covid levels (Sharma, Yadav & Jha, 2018). The reasons behind this development are shared below:
- The Australian government have been able to control the pandemic when compared to the neighbouring and other countries. This has boosted the confidence of the customers in the country and driven investment into the country from foreign markets in search of stability.
- During the early days of the pandemic, the economy's consumption level was declining, and unemployment rates in the nations were rising. As a result, investors have been forced to seek for secure investment options, one of which is the US dollar. The RBA used quantitative easing techniques and created a $100 billion bond purchase programme, allowing the government to expand investment and expenditure while keeping interest rates low.
- Effective controlling of the covid-19 pandemic helped the country to quickly resume its trading activities. A rise in demand from the biggest importer of the country in the form China allowed Australia to improve the prospects of the country eventually raising the exchange rates. The following table represents the country wise trading details with the Australian economy:
- Due to the US Fed's $3 trillion bond purchase operation, most of the cash that went out during the flight to safety and the outbreak of the epidemic was restored in the country. The capital returned in the country was used by the government to promote public welfare schemes and increase the credit liquidity in the economy.
Future Exchange Rate
Future rates can be defined as the future expected values of the spot rate and the AUD/USD futures exchange rates behaves in line with the spot rate of the currency. Since the beginning of the year 2017, the AUD/USD futures have been trading at a discount continuous for a period of 21 months. The RBA has chosen a dovish economic strategy, which the market has interpreted as a negative indicator for currency rates in the future (RBA.gov.au, 2021). Due to waning consumer confidence, future AUD/USD rates are expected to fall through the end of 2019. Monthly future rates from the middle of 2019 to the end of 2020, on the other hand, reveal that future rates are at a premium. The following might be the cause of the above-mentioned occurrence:
- Efficient management of the covid-19 pandemic.
- Improvement in the economic situations of the country.
- Rise in the price of the commodities.
- The Chinese recovery from the covid-19 pandemic benefitted the Australian.
- Rise in equity markets.
Expected reasons for the US dollar's depreciation, causing the AUD/USD to rise.:
- Infrastructure spending may cause the US currency to decrease.
- Fears of inflation rising
- To encourage exports and reduce imports, the US Federal Reserve must lower the dollar.
Testing IRP, PPP, and IFE
1) IRP- The concept of IRP advocates that the investors should not think about the difference in return on securities of different countries as the gain earned due to the interest rate would be offset by the change in exchange rate. The interest rate discrepancy should affect the future currency rate. The following are the steps that are involved in the IRP:
- Expected forward rate calculations - Spot rate*(int rate of home/int rate of foreign)
- The IRP is not valid if the future rate does not match the projected forward rate.
- Arbitrage opportunity is available in the above case.
According to our study as represented in table 1 in appendix, the IRP does not hold good.
2) PPP- The theory of PPP suggests that the exchange rate between countries should be equal if the purchasing power is similar in the countries concerned (Arize, Malindretos & Ghosh, 2015). Our study finds that the realised future rates are in accordance with PPP using prices from the big mac index.
3) IFE- The difference in exchange rates between two countries is equal to the difference in nominal interest rates between the two countries, according to this theory (Yaya, 2015). The exchange rates, according to our data, do not depart significantly from the IFE principles (refer table 2 in appendix).
The purpose of the paper was to assess the AUD/USD exchange rate changes over a five-year period. The study began with an explanation of the movement in the exchange rate as well as the logical explanations for the movement, which included central bank policies and economic developments. The study then looks at past and projected rates, as well as the variables that influenced them. The report's last section compares real exchange rates between Australia and the United States to values calculated using various currency determination algorithms. The currency rates fulfilled two of the forecasting tools, but not the IRP technique of forecasting, according to the report.
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Kasahara, H., Sawada, Y., & Suzuki, M. (2016). Monetary Policy and Covered Interest Parity in the Post GFC Period: Evidence from the Australian Dollar and the NZ Dollar (No. CIRJE-F-1033). CIRJE, Faculty of Economics, University of Tokyo.
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Sharma, S., Yadav, M. P., & Jha, B. (2022). Impact of the COVID-19 Outbreak on the Currency Exchanges of Selected Countries. International Journal of Sociotechnology and Knowledge Development (IJSKD), 14(2), 73-91.
Supporting the Economy and Financial System in Response to COVID-19 (2021). Available at: https://www.rba.gov.au/covid-19/ (Accessed: 31 March 2022).
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