Case Study-AW242

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General Instructions.
 
Please form groups of three to five people in order to solve either of the two “minicases” below. You have a month to complete the work: the due date for this group assignment is the last day of the final exam period at 5PM.
 
You have two choices
 

(i) Case Choice #1: real exchange rates and competitive positions of US, Australian and Brazilian companies.
 
(ii) Case Choice #2: drivers of nominal vs. exchange rate changes in Turkey.
 

Completing the second choice requires carrying out regression analyses. That case is thus more demanding quantitatively, so that successful completion yields a 10% grade bonus (i.e., your raw grade is multiplied by 1.1). There is a similar 10% bonus if you solve part (2) of Choice #1.
 
In order to handle this second assignment, please remember that no collaboration is allowed between groups (of course, maximum collaboration is expected within a given group). If you have any doubts about the honor code that governs the completion of this assignment, please consult the course syllabus or talk to me!
 
Case Choice #1– USD, Commodity Currencies and Purchasing Power Parity.
 
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Mr. Henry Guessright (a principal of Veritas Emerging Market Fund, LLC) is interested in commodity currencies. He foresaw, back in 2002, that a commodity “super-cycle” would soon materialize amid strong growth in emerging economies (especially China) and output constraints in commodity-producing countries. He correctly guessed that the resulting commodity price IM-2 boom would drive up local currencies’ values in commodity-producing countries – in particular Australia (coal, iron), Brazil (iron, soybeans, sugar), Russia (oil) and South Africa (coal, gold). Back in 2007, when commodity prices reached unheard-of heights, and in 2010, after they rebounded once the Great Recession had ended, Mr. Guessright became concerned with changes in the competitive standing of non-commodity firms in commodity-producing countries (i.e., companies that produce goods or services outside of the “primary” sector of those economies).
 

We are now at the end of 2014, and this time Mr. Guesswright thinks that the opposite situation is taking place amid a sharp drop in commodity prices (almost 50% for oil and iron ore). As members of his team, he has tasked you with preparing a report on real exchange rate changes in Australia and Brazil (the two countries where he’s thinking of making a move there is a substantial non-commodity manufacturing sector).
 
(Q1) Mr. Guessright feels that the major worry for non-commodity companies in commodity-exporting countries is competitiveness with China. He believes that China has managed its currency with respect to the U.S. dollar in the past and will, in the future, continue to do so. Hence, he would like you to do the following:
 
a. Using monthly data (the highest frequency at which inflation information is published), create plots of the past (nominal) exchange rate levels and percentage changes against the monthly inflation differential between the USA and, respectively, Australia or Brazil.
 
b. Using monthly CPI and FX data (provided on the course website), plot the time series of the real exchange rate in the past 24 years (Brazilian Real vs. USD, and Turkish Lira vs. USD).
 
c. Using the above graphs, comment on possible changes in the competitive positions of, respectively, Australian and Brazilian firms compared to U.S. firms.
 
(Q2 – 5% grade bonus) Mr. Guessright is considering investing in a Brazilian company that exports 50% of its output to the USA and 50% to Australia. He wonders how FX rate changes will affect the company’s position against US and Australian competitors in 2015. Please help!
 

Case Choice #2 – USD, Turkish Lira and Purchasing Power Parity.
 

Veritas Emerging Market Fund, LLC specializes in investing in the world’s emerging stock markets. Mr. Henry Guessright (the same person as in Choice # 1) is an experienced hand at the firm; he is also your boss. He is currently interested in the Turkish stock market. He correctly anticipated, back in 2004-2005, that Turkey would be invited to negotiate its membership in the European Union and that this development would boost the stock market in Turkey. Ten years later, as of late Fall 2014, he is quite concerned with the potential for exchange rate volatility in Turkey and would like to understand what has historically driven Turkish exchange rates.
 
Since the inflation rate has often, in the past, been higher (or much higher) in
Turkey than in the USA, he is guessing that purchasing power parity has prevailed – at least to some extent. As members of his team, he has tasked your group with checking this out. In other words, you have to prepare a report on the following question: Does purchasing power parity typically hold for the Turkish lira-U.S. dollar exchange rate?
 
As a first pass, Mr. Guessright would like you to do the following
 

a. Using monthly data (the highest frequency at which inflation information is available from public sources), please plot the Turkish lira-U.S. dollar exchange rate percent changes against the inflation-rate differential between Turkey and the U.S. (Jan. 1991 – Nov. 2014).
 
b. Regress percentage exchange rate changes on the inflation differential and provide estimates of the intercept and of the slope coefficient. Interpret the regression results.
 
c. Even if PPP did not hold perfectly every month since 1991, it is still possible that inflation differentials nevertheless drove the bulk of nominal exchange rate changes over time. The way to check is to see if the real exchange rate (RER) went up or down substantially for long periods of time. Using Jan. 1991 and Jan. 2002 as alternative reference months, plot the RER (Turkish Lira vs. USD) (i) since 1991, (ii) in 1991-2001 and (iii) in 2002-2014. Discuss!
 
d. Compare the respective explanatory powers of PPP vs. uncovered IRP in the 1991-2001 and 2002-2014 sub-periods. Have PPP and/or UIRP held at different horizons (say, 1 month, 3 months, 6 months, 1 year, or even 2-3 years)?
 
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