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Monday 9th December 2013

UK/US Exchange Rate Financial Markets and Instruments

Cassio Domingues Veena Kalwani Rishabh Kothari

Luiz Secco

All members in FIN3560-02

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“The authors of this paper hereby give permission to Professor Michael Goldstein to distribute this paper by hard copy, to put it on reserve at Horn Library at Babson College, or to post a PDF version of this paper on the internet

“I pledge my honor that I have neither received nor provided any unauthorized assistance during the completion of this work”.

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Table of Contents: 1. Executive Summary………………………………………..…………….....3

2.What is the Foreign Exchange Market?..........................................................4

2.1. Current Events in the Forex Market………………...…………….6

2.2. Forex Market in the US and the UK………………..….………….6

3. Graphical Analysis of the Fluctuations in the Exchange Rate..…….………7

3.1. Recessions in the United States (1972-2012)………..…….……...7

3.2. Recessions in the United Kingdom (1972-2012)……...…….…….8

4. Factors that affect the UK/US Exchange rate…………………...………....10

4.1. Inflation………………………………………………...…….…..10

4.2. Federal Funds Rate (Interest Rate)……………………...….…….11

4.3. Unemployment Level………………………………….....………11

4.4 GDP Growth……………………………………………...……….11

4.5. Trade Balance…………………………………………...………..12

4.6. Public Debt(%GDP)……………………………………...………12

5. Regression Analysis…………………………………………….…...……..12

5.1. Regression 1-Levels in Inflation, Interest Rate, and

Unemployment………………………………………………………..13

5.2. Regression 2-Changes in Inflation, Interest Rate, and

Unemployment…………………………………………………..……14

5.3. Regression 3-Changes in Inflation, Interest Rate, and

Unemployment………………………………………………………..14

5.4. Regression 4-Levels in Inflation, Interest Rate, Unemployment, Trade

Balance, Public Debt (as a %GDP), and GDP Growth……………….14

5.5 Regression 5- Changes in Inflation, Interest Rate, Dummy Weekend, Dummy

US Holidays…………………………………………….......................16

6. Forecasting Model………………………………………………………….17

7. Conclusion………………………………………………………………….17

8. Works Cited………………………………………………………………...19

9. Exhibits…………………………………………………………………..…22

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1.Executive Summary This research paper consists of examining the Foreign Exchange Market, analyzing the

effect of the 6 variables (inflation, interest rates, unemployment, trade balance, public debt and

GDP growth both in the UK and US), and the effect of weekends and holidays on the foreign

exchange rate between the US and the UK.

We begin by introducing the Foreign Exchange Market and understanding the history of

the market. Currently it is a $5.3 trillion-a-day market with the UK contributing to 41% of the

trades and the US 19% of the trades. To better understand the history between the GBPUSD, we

examined the fluctuations in their exchange rates from 1972 to 2012. This helped us recognize the

important factors that affect the value of the exchange rates.

Next we examined the importance and the intricacies of each variable and ran several

regression analyses to determine to what extent each variable affects the exchange rates. The first

two regressions determine the differences in using percentage changes versus actual levels of the

selected variables. We discovered that by using levels, we get a higher R2 (explained in

Regression Analysis section), thus improving the probability of our results. From there we added

some other variables to our regression, to further see the impact on the exchange rate, and this

resulted in better results.

From our results, we noted that no single factor could accurately determine the exchange

rate and that is the beauty of the foreign exchange market. This is the reason why bearish and

bullish markets exist, due to speculation on what could happen to the various variables that

influence the exchange rate.

Finally, we ran a regression model to give us a forecast of 2012’s exchange rates by using

the data from 2011. Our forecasted exchange rates for 2012 were close to the actual rates with an

average difference of 1.17%, however, it failed to predict whether the exchange rate would move

positively or negatively in 4 of the 12 tested periods.

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2. What is the Foreign Exchange Market? The Foreign Exchange Market, also known as FX or Forex, is a market in which

participants are able to buy, sell, exchange and speculate on currencies1. The Foreign Exchange

Market determines the relative value of one currency for another. Due to the increased

globalization of our business and personal lives, this market determines how much we can spend,

in terms of the currency we own, in another country. Additionally, it aids financial managers to

understand how current world events and movements in other financial markets affect the

profitability and performance of their own companies2. The participants of the foreign exchange

market include3:

• Consumers and travelers: for online purchases or traveling

• Businesses: for trading and international operations

• Investors and speculators: for foreign investments (bonds, real estate, etc.)

• Commercial and investment banks: an additional service to commercial banking

• Government and central banks: to improve economic conditions

The FX market is considered to be one the largest financial markets and the most liquid

market in the world4. Trading on this market is available to anyone 24 hours a day, for five days

a week, thus fluctuations in exchange rates continues throughout the day even while some

financial institutions may be closed5. Trading begins in the Asia-Pacific region followed by the

Middle East, Europe and America6. According to a survey done by the Bank for International

Settlements, the foreign exchange market has now become a $5.3 trillion–a-day market7, with

spot market trading accounting to over one-third of daily turnover8. Trading activity is the

heaviest when major markets such as Japan, England and America, overlap9. Over 50% of Forex

transactions are conducted in the UK and in the US, and the most commonly traded currency is

the EURUSD10.

A foreign exchange rate is the price at which one currency can be exchanged for another

currency11. Currencies are usually traded in pairs: “GBPUSD”, which means trading the British

pound against the US dollar. The first currency in the above quotation is known as the “base” or 1 "Foreign Exchange Market." 2 Financial Markets and Instruments (page 275) 3 "Forex Market Participants." 4 "Foreign Exchange Market." 5 Financial Markets and Instruments (page 277) 6 "Forex Market Overview." 7 "The $5.3 Trillion a Day Currencies Market: 5 Things You Need to Know." 8 "Forex Market Overview." 9 "Forex Market Overview." 10 "What Is Forex?" 11 Financial Markets and Instruments (page 276)

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bid currency whereas the second currency is known as the “quote” or ask currency. The rates are

expressed as the bid and ask price of the currency pair. For example, GBPUSD price of 1.61

means that 1£ is equivalent to $1.61.

The spread, which is the difference between the bid and ask price, is an important factor

when talking about Forex. The spread is also considered to be the cost of trade12. For example if

GBPUSD bid and ask prices are 1.6093 and 1.6095 respectively, the spread is 2 points or 2 pips.

A pip is the smallest movement up or down in the price of a currency13.

Forex trading involves trading currencies that are pairs, thus it requires speculating on

rising (bullish) and falling (bearish) markets. The first step in trading Forex is to consider whether

the currency you want to trade with, will rise or fall. In a buy position, you believe that the value

of the base currency will rise against the quote currency. In a sell position, you believe that the

value of the base currency will fall against the quote currency. For instance if you were to sell

GBPUSD (1.6093 and 1.6095), the trade is entered as the bid price of 1.6093. Assume that later

that day, the GBPUSD is at 1.6080 and 1.6090, this would mean that your trade has lost 13 pips,

or $13 (1 pip=$1).

Currency trading also includes foreign exchange risk14, which is the risk that cash flows

will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a

change in the foreign exchange rates. For instance if a foreign exchange currency depreciates (a

country’s goods and services become cheaper for foreign buyers and foreign goods and services

become more expensive for foreign sellers) in relative to the U.S dollar, the dollar value of the

cash flows received will fall. If it appreciates (value of currency rises thus the country’s goods

and services are more expensive for foreign buyers and foreign goods are cheaper for foreign

sellers) relative the U.S dollar, the dollar value of the cash flows will increase15.

There are two types of foreign exchange transactions: spot foreign exchange transactions

and forward foreign exchange transactions. Spot transactions are the immediate exchanges of

currencies at current exchange rates. Forward transactions are the exchanges of currencies at a

specified rate at a specified date in the future.

12 "Benefits of Forex Trading." 13 "How to Trade Forex?" 14 Financial Markets and Instruments (page 276) 15 Financial Markets and Instruments (page 276)

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2.1Current Events in the Forex Market Currency-trading volumes in the United States averaged to about $77 billion a day and

spot transactions averaged to $97 billion in October, which is the lowest it has been since 2006

and 2010 respectively16.

The United Kingdom’s Financial Conduct Authority has been investigating the utilization

of financial personal accounts of foreign exchange market traders who have been accused of

capitalizing on these accounts to trade their own money in advance of their clients’ orders17. Nine

of the largest banks in currency trading have announced that they are undergoing investigations

about the manipulation of the foreign exchange markets, including, Goldman Sachs, UBS,

Citigroup, Barclays and Deutsche Bank. 18 Chat rooms are facing inspections from regulators as a

place for possible collusion and market manipulation. 19 Measures taken by banks like UBS

include the banning of social media at the workplace and permitting client chat rooms only when

accompanied by a supervisor.20 Many banks are also considering banning all chat rooms in order

to avoid more scandal.21

On December 5h 2013, the GBP/USD opened at 1.6376 and rose to 1.6402.22 It fell to

1.6299, its lowest point in the day, reacting to the drop in the US unemployment rate to 7% and

rising GDP of 3.6%. 23

2.2 Forex Market in the US and the UK The UK is the largest trading center in the world, accounting for 41% of the trading,

(between the hours of 8AM and 5PM GMT).24 The US is the second largest trading center in the

world (between the hours of 8AM and 5PM EST). Trading during this time constitutes 22% of

the world’s total currency trading volume for the day. Most of this trading takes place in New

York (19%) and thus is the headquarters for the US trading session25. The 1941 policy of Bretton-

Woods Accord has played a major role in the Forex Market internationally. Currencies from then

were pegged to the US dollar which in turn has been pegged to the price of gold in order to

minimize the economic and financial chaos26. In 1971, President Nixon eliminated the pegging of

the US dollar to the price of gold to avoid the rising prices of gold and inflation, thus forming the

16 "Fresh FX Figures Add Up to a Year to Forget." 17 "FOREX NEWS: UK Regulators Investigate Forex Traders’ Private Accounts." 18 "Goldman Discloses Foreign Exchange Inquiry." 19"UBS Restructuring Forex Unit." 20"UBS Restructuring Forex Unit." 21"UBS Restructuring Forex Unit." 22 "Forex: GBP/USD: Halifax HPI up 1.1% in November; BoE: Consumers Expect 3.6% Inflation." 23 "Forex: GBP/USD: Halifax HPI up 1.1% in November; BoE: Consumers Expect 3.6% Inflation." 24 "Singapore Overtakes Japan as Asia's Top Foreign-Exchange Hub." 25 "The Best Times to Trade the US Dollar." 26 “Forex Training Summary and Quiz."

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free-floating currency exchange rates27. The Chicago Mercantile Exchange (CME) was the first

to offer currency trading and in 1971 it launched the International Monetary Market, the largest

futures exchange in the United States28.

3. Graphical Analysis of the Fluctuations in the Exchange Rate (Refer to Exhibit 1)

3.1 Recessions in the United States (1972-2012) From 1972 to 2012 there have been four major drops due to recessions in the U.S. (see

Exhibit 1). These recessions have impacted the economy by creating significant fluctuations in

the foreign exchange market.

1973-1975 Recession:

In 1973 much of the western world came upon a period of economic stagnation, marking

the end of the post-World War II economic boom. This was caused by several factors, such as:29

Oil Crisis: OPEC quadrupled oil prices for a couple of months during 1973, which

greatly affected most countries that purchased oil from OPEC. Since the U.S. is one of

the leading consumers of oil, it was one of the economies that was most affected.30

Gold Standard: One of the economic measures taken by President Nixon was taking the

U.S. off the gold standard, therefore being able to print more money. However, by doing

so this created inflation, since there was a larger supply of dollars for the same amount of

goods available.31

Results: These economic measures lead to stagflation, which is when the economy

experiences stagnant economic growth, high unemployment, and high inflation. The

result of this were three consecutive quarters of negative GDP growth, and

unemployment reached a peak of 9% in 1975, two months after the recession ended.32

1980- 1982 Recession:

At the beginning of the 80’s the U.S. economy entered, at the time, the biggest recession

since the Great Depression. The causes to this recession were several issues both foreign

and domestic, such as:33

Oil Price Increase: One of the causes of the early 1980s recession was the Iranian

Revolution of 1979, which sparked a second large round of oil.34

27 “Forex Training Summary and Quiz." 28 “Forex Training Summary and Quiz." 29 "The History of Recessions in the United States." 30 "1973-74 Oil Crisis." 31 "The History of Recessions in the United States." 32 "The History of Recessions in the United States." 33 "1980-82 Early 1980s Recession." 34 "1980-82 Early 1980s Recession."

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Restrictive Monetary Policy: The restrictive monetary policy, which was intended to

hold back inflation, dampened economic growth period.35

Results: This resulted in unprecedented federal budget deficits and a huge increase in the

US national debt. 36

1990-1991 Recession

From November 1982 to July 1990 the U.S. economy experienced robust growth, modest

unemployment, and low inflation.37

Stocks Crash: On October 19, 1987 stock markets around the world crashed. The Dow

Jones Industrial Average lost over 22% of its value. Many people viewed this as a sign

that investors were worried due to inflation caused by the U.S. budget deficit.38

Real Estate Loans: In the late 1980’s many savings and loan associations went bankrupt

due to bad loans. The collapse of the S&L industry impacted American welfare and

forced the government to bailout certain financial institutions.39

Interest Rates: In the late 1980’s the Federal Reserve raised interest rates in attempt to

control the crisis. 40

Iraq's invasion of Kuwait in the summer of 1990: During this invasion oil prices

ascended and consumers lost confidence in the market.41

Results: Unemployment reaching almost 8% as late as June 1992. 42

3.2 Recessions in the United Kingdom (1972-2012) From 1972 to 2012 there have been 4 recessions in the U.K. which have impacted its

economy creating significant fluctuations in the Foreign Exchange market.

Stagflation (1973-1975)

The west's long postwar boom came to an end in the autumn of 1973, when the Yom

Kippur War resulted in a fourfold increase in oil prices.43

Oil Crisis: The UK did not support Israel during the Yom Kippur War but it still suffered

from the embargo. However, OPEC’s decision to raise oil prices affected the UK. 44

35 "1980-82 Early 1980s Recession." 36 "The History of Recessions in the United States." 37 "1990-92 Early 1990s Recession." 38 "1990-92 Early 1990s Recession." 39 "The History of Recessions in the United States." 40 "The History of Recessions in the United States." 41 "1990-92 Early 1990s Recession." 42 "1990-92 Early 1990s Recession." 43 "British Recessions: A Short History." 44 "Background: What Caused the 1970s Oil Price Shock?"

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Miner’s and Railroad Worker’s Strikes: In addition to the oil crisis, many railroad

workers and miners went on strike, which lead to a 3-day week in 1974 which aggravated

the situation and elevated the price of heating oil and coal. 45

Results: Because of these events unemployment and inflation rose, and the annual

increase in the cost of living hit a postwar peak of 26% by the summer of 1975.46

Manufacturing Meltdown: 1980-81

Margaret Thatcher came to power in 1979 convinced that radical action was needed to reverse

Britain's relative economic decline. Inflation was at 10% and there were about 1,500,000 people

unemployed.47

Interest Rates: In an attempt to control inflation, Margaret Thatcher devised new

monetary policies which raised interest rates.48

Manufacturing Inefficiency: Thatcher changed trade union laws to control inflation in

an attempt to avoid more strikes and closed many factories, shipyards, and coal pits.49

Results: Inflation was reduced (falling to 4% in the spring of 1983); however, because of

the closing of many factories and work places, unemployment rates rose to more than

3,000,000 people in the mid 1980’s.50

Lawson's Legacy: 1990-92

By the end of the 1980s inflation was getting out of control (9.5% in 1990) and so the chancellor

eventually persuaded Mrs. Thatcher to join the ERM.51

Exchange Rate Mechanism: In October 1990 the UK entered the ERM in an attempt to

control inflation. Two years later it was forced to exit after the pound sterling came under

pressure from currency speculators.52

Financial Contagion: The stock collapse in 1987 led to a sharp recession in the U.K. and

around the world due to financial contagion, affecting those countries that were closer

economically to the U.S. such as the U.K. 53

Housing Market: In the late 80’s the rise in house prices led to a rise in consumer wealth

and spending. However, the high interest rates in the early 90’s caused a fall in house

45 "British Recessions: A Short History." 46 "British Recessions: A Short History." 47 “UK Recession in 1980: What Was It Like?" 48 “UK Recession in 1980: What Was It Like?" 49 "UK Economy in the 1980s." 50 "UK Economy in the 1980s." 51 "British Recessions: A Short History." 52 "Lessons Learned on Black Wednesday." 53 "Setting the Record Straight on the Dow Drop."

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prices and repossession. Consequently this led to negative wealth effect, which left

homeowners with negative equity.54

Results: The early 1990s recession was officially the longest in Britain since the Great

Depression. Unemployment in Britain rose by 87.5% between April 1990 and February

1993. Following the recession the British economy grew for 15 straight years until the

financial crisis of 2008.55

Financial Crisis: 2007-2008 (Both the U.S. and the U.K.)

In the years of 2006 and 2007 the housing market in the U.S. collapsed. However, due to

globalization and how global banking systems were interconnected, this crisis took a toll on many

countries and markets around the world, which came to be the worst since the great depression.56

Banking System: Many large financial institutions were heavily invested in the

mortgage market in the U.S. Therefore, with the downfall of the housing market these

financial institutions had a huge loss in their balance sheets.57

Loss of Faith: Due to the failure of some prestigious institutions such as Bear Sterns and

Lehman Brothers, many investors started to question bank solvency bringing the stock

markets down. 58

Government Bailout: Due to the failure of some financial institutions the American

government intervened trying to bailout those that failed in order to restore economic

growth.59

Results: Although the crisis originated in the U.S., the financial crisis which broke out

was worldwide. Economic globalization meant that even those that did not live in the

U.S., but had invested in their financial markets were exposed to the negative effects.60

4 Factors that Affect the UK/US Exchange Rate 4.1 Inflation

Inflation is the general increase in prices over a period of time. To understand how

inflation affects the exchange rate between the UK and the US we need to consider the

purchasing power parity, which is, “a rate of exchange between two currencies that gives them

equal purchasing powers in their own economies.”61 Higher inflation in the UK will mean that

54 "Remember the Last Recession?" 55 "1993: Recession over - It's Official." 56 "2007-09 Financial Crisis." 57 "UK Recession: Timeline of How the British Economy Has Been Hit." 58 "2007-09 Financial Crisis." 59 "UK Recession: Timeline of How the British Economy Has Been Hit." 60 "2007-09 Financial Crisis." 61 "Purchasing Power Parity."

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UK goods will become more expensive, and thus making their exports more expensive. Since

demand for UK exports will decrease it will lead to a decrease in demand for the Pound Sterling,

and therefore, the value of the currency will depreciate. On the flip side, since UK goods are more

expensive, local consumers will seek alternatives making UK imports increase. In order to import

goods, consumers will have to increase the supply of the Pound Sterling, which will depreciate its

value. The same would happen to the US Dollar if inflation were to increase in the US. Since,

inflation in both countries is at different rates, the relative price of goods would be different so the

Purchasing Power Parity wouldn’t hold.

The Fisher Equation states:

1 + 𝑛 = 1 + 𝑟 (1 + 𝜋!)

Hence, we know that if real interest rates are held constant, then an increase in inflation is

met with an increase in the nominal rate.

4.2 Federal Funds Rate (Interest Rate) The Federal Funds Rate is the interest rate at which depository institutes borrow from one

another. When interest rates increase, price of securities (for example a bond) will decrease and

the yields on these securities will increase. This means investors will be more willing to buy these

securities. In order for international investors to purchase US securities, they must first buy US

Dollars. This will cause an increase in the demand for US dollars and therefore, the value will

appreciate. If the investors are from the UK, they will be selling Pound Sterling in order to buy

the US Dollars and this will cause the supply of the Pound Sterling to increase and therefore, its

value will depreciate.

4.3 Unemployment Level Unemployment level is also usually analyzed to predict exchange rates since it directly

affects current and future consumption habits. An increase in unemployment levels implies that a

greater percentage of the population is not receiving regular salary; therefore, it indicates a

decrease in the country’s total income and, consequently, consumption level. This would result in

lower demand for goods and services and, thus, lower inflation.

3.4 GDP Growth The GDP is the market value of all final goods and services produced within a country in

a given period of time. The output approach is based on the principle that all products must be

bought by somebody and, thus, the value of a country’s total production must be equal to its total

expenditure. The expenditure method of calculating GDP states that:

GDP = Consumption + Gross Investments + Government Spending + (Exports – Imports).

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An increasing GDP indicates a growing economy and, therefore, GDP growth is used to

measure the level of employment, income and inflation within the economy.62 Since GDP growth

can be a reflection of increasing consumption due to higher income levels and, therefore,

purchasing power it may be an indicator of higher inflation. Additionally, as an economy grows

in a higher rate relative to other economies, the demand for imports increase relative to the

demand for exports since goods that would be exported get consumed domestically. GDP growth,

therefore, can be a factor that leads to currency depreciation due to higher inflation and lower

exports.

4.5 Trade Balance The trade balance or net exports is the difference between a country’s exports and

imports and is part of the above mentioned method for determining a country’s GDP. The trade

balance is an important factor for determining a country’s foreign exchange rate since it reflects

the difference in demand and supply of a country’s currency. A positive trade balance indicates

the country’s exports are greater than its imports and, therefore, that the demand for its currency

is higher than its supply, which causes the country’s currency to appreciate and vice versa.

4.6 Public Debt (% of GDP) Public debt is defined as the total debt owed by a central government. In the case of the

United States, public debt is the total value of Treasury securities that have been issued by the

Treasury and other Federal agencies, which are outstanding at a specific point in time.63 A high

debt level, for example, may result in high inflation if currency devaluation is used as a solution

for debt reduction. 5 Regression Analysis P-Value

We use each of the individual p-values to compare to our significance level. If the p-

value is less than 1%, then, we know that the variable is statistically significant 99% of the times.

If a variable is not statistically significant it means that the data occurred only due to chance alone

and not because of other independent variables.

R Squared

The R2 tells us how much of the variation in the foreign exchange rates from pounds to

dollars are due to the variables which we have just described.

Standard Error of the Estimate (S.E)

The S.E. displays the variation of our predictions. This number shows how our

predictions might fluctuate; basically meaning that by using this equation to predict future foreign

62 "GDP Data." 63 "Federal debt basics – How large is the federal debt?"

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exchange rates we can be off by ± “x” pounds to dollars. Basically we can have a prediction that

is either over or under the actual number by “x”. This tool is very important because it slims

down our margin for error.

5.1 Regression 1- Levels in Inflation, Interest Rate, and Unemployment (Exhibit 2) Foreign Exchange Rate = 0.525 - 0.01009 US Inflation – 0.00107 UK Inflation - 0.003189 US

Interest Rate + 0.00033 UK Interest Rate – 0.00479 US Unemployment + 0.02149 UK

Unemployment

R2= 59.54% S.E = .05796

The constant in this regression is 0.525, which is what the foreign exchange rate would be if all

the other variables in this regression would be equal to 0.

US Inflation, - 0.01009, is an independent variable. On average, if the US inflation goes up by 1%

then the foreign exchange rate will be decreased by 0.01009 pounds to dollars, assuming all

variables are constant.

UK Inflation, – 0.00107, is an independent variable. On average, if the UK inflation goes up by

1% then the foreign exchange rate will be decreased by 0.00107 pounds to dollars, assuming all


US Interest Rate, - 0.003189, is an independent variable. On average, if the US interest rate goes

up by 1% then the foreign exchange rate will be decreased by 0.003189 pounds to dollars,

assuming all variables are constant.

UK Interest Rate, 0.00033, is an independent variable. On average, if the UK interest rate goes up

by 1% then the foreign exchange rate will be increased by 0.00033 pounds to dollars, assuming

all variables are constant.

US Unemployment, – 0.00479, is an independent variable. On average, if the US unemployment

rate goes up by 1% then the foreign exchange rate will be decreased by 0.00479 pounds to

dollars, assuming all variables are constant.

UK Unemployment, 0.02149, is an independent variable. On average, if the UK unemployment

rate goes up by 1% then the foreign exchange rate will be increased by 0.02149 pounds to dollars,


The R2 of this equation is 59.54%, which means that 59.54% of all the differences in foreign

exchange rate from pounds to dollars in our set of data are explained with the use of our 6

independent variables. This tells us that statistically we can correctly prove there is a relation

between the foreign exchange rate and our independent variables 59.54% of the time.

The S.E of this equation is 0.057959, which means we can predict future foreign exchange rates

and be off by ± 0.057959 pounds to dollars.

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According to this regression model, the only variables that are significant (<0.0001 p-value) are:

US Inflation and UK Unemployment.

5.2 Regression 2- Changes in Inflation, Interest Rate, and Unemployment (Exhibit 3) Foreign Exchange Rate = 0.10905 - 0.00362 US Inflation – 0.01312 UK Inflation + 0.00341 US


Unemployment

R2= 2.46% S.E = 2.92361

For our second regression analysis, we chose the same variables as our first regression

but decided to use percentage changes rather than actual levels. After running the regression, our

results weren't as correlated as our first regression. We got a new R2 of 2.46% which was

significantly lower than our previous R2.

The explanation for this is since inflation is already a percentage change of Consumer

Price Index, taking a percentage of inflation misrepresents the amount. Since inflation levels are

given as percentage changes, comparing them to other variables that are pure percentages skews

our results.

5.3 Regression 3- Changes in Inflation, Interest Rate, and Unemployment (Exhibit 4) Foreign Exchange Rate = 0.00054- 0.93644 US Inflation – 0.46857 UK Inflation + 0.15383 US


Unemployment

R2= 10.06% S.E = 0.02353

For this regression, we adjusted the percentage changes used in the previous regression.

After running the regression, our results still weren't as correlated as our first regression. We got a

R2 of 10.06%, which was higher than the previous R2, but was significantly lower than the R2

obtained using levels instead of changes. The independent variables that were statistically

significant in this regression, given a 95% confidence level, were US inflation and UK interest

rates.

5.4 Regression 4- Levels in Inflation, Interest Rate, Unemployment, Trade Balance, Public Debt (as a % of GDP), and GDP Growth (Exhibit 5) Foreign Exchange Rate = 1.12101 + 0.00337 US Inflation + 0.00736 UK Inflation + 0.00851US

Interest rates – 0.04840 UK Interest rate - 0.00229 US Unemployment – 0.01051 UK

Unemployment + 0.00343 US Trade balance + 0.00657 UK Trade balance –0.00079 US Public

debt – 0.00136 UK Public debt – 0.00574 US GDP – 0.01013 UK GDP

R2 = 69.47% SE = 0.03145

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The constant in this regression is 1.12101, which is what the foreign exchange rate would be if all

the other variables in this regression would be equal to 0.

US Inflation, 0.00337, is an independent variable. On average, if the US inflation goes up by 1%

then the foreign exchange rate will be increased by 0.00337 pounds to dollars, assuming all


UK Inflation, 0.00736, is an independent variable. On average, if the UK inflation goes up by 1%

then the foreign exchange rate will be increased by 0.00736 pounds to dollars, assuming all


US Interest Rate, 0.00851, is an independent variable. On average, if the US interest rate goes up

by 1% then the foreign exchange rate will be increased by 0.00851 pounds to dollars, assuming


UK Interest Rate, – 0.04840, is an independent variable. On average, if the UK interest rate goes



US Unemployment, - 0.00229, is an independent variable. On average, if the US unemployment



UK Unemployment, – 0.01051, is an independent variable. On average, if the UK unemployment



US Trade Balance, 0.00343, is an independent variable. On average, if the US trade balance, rate

goes up by 1% then the foreign exchange rate will be increased by 0.00343 pounds to dollars,


UK Trade Balance, 0.00657, is an independent variable. On average, if the UK Trade balance,

rate goes up by 1% then the foreign exchange rate will be increased by 0.00657 pounds to dollars,


US Public Debt, –0.00079, is an independent variable. On average, if the US Public Debt goes up

by 1% then the foreign exchange rate will be decreased by 0.00079 pounds to dollars, assuming


UK Public Debt, – 0.00136, is an independent variable. On average, if the UK Public Debt goes



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US GDP Growth, – 0.00574, is an independent variable. On average, if the US GDP rate goes up



UK GDP Growth, – 0.01013, is an independent variable. On average, if the UK GDP rate goes up



The R2 of this equation is 69.47%, which means that 69.47% of all the differences in foreign

exchange rate from pounds to dollars in our set of data are explained with the use of our 12

independent variables (Both for UK and US). Statistically this tells us that we can correctly prove

that is a relation between the foreign exchange rate and over variables 69.47% of the time.

The S.E is equal to 0.03145, which is significantly lower than the first two regressions. This not

only tells us that this regression model is better, but also, helps us predict future foreign exchange

rates within ± 0.03145 pounds to dollars.

According to this regression model, the variables that are significant (<0.0001 p-value)

are: UK interest rates and US trade balance. Adding these variables to our regression model has

made our regression more reliable and now we can accurately tell which variables are important

when considering the foreign exchange rate.

5.5 Regression 5- Changes in Inflation, Interest Rate, Dummy Weekend, Dummy US Holidays (Exhibit 6) Foreign Exchange Rate = 0.00002 + 0.00340 US Inflation + 0.13078 UK Inflation + 0.24626US

Interest Rates + 0.35506UK Interest Rates + 0.00023 Dummy Weekend + 0.00047 Dummy US

Holidays

R2 = 67.43% SE = 0.00989

The purpose of this regression is to analyze how the UK/US exchange rate changes

during the days when there is less active trading such as weekends and holidays. In this model we

chose to use percentage changes instead of levels and still got a high R2, which can explained due

to the fact that we used daily data, as opposed to monthly or yearly, and thus a larger data sample.

In order to do this we used 10 years of daily data (from the beginning of 2003 to the end of 2012)

for changes in the UK/US exchange rate, US inflation, UK inflation, US interest rates, UK

interest rates and included dummy variables for weekends and financial markets’ holidays in the

US. A dummy is used to determine how the presence of a qualitative effect may be expected to

influence the outcome of the regression analysis. The dummy variable takes on a value of 1 when

its coefficient acts to alter the independent variable. For this reason, in the “Dummy Weekend”

data, weekdays had a value of 0, while weekend days took on a value of 1. Also, while in the

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“Dummy US Holidays” variables every US financial market holiday within the last 10 years also

had a value of 1.

The coefficients of the dummy variables explain that, on average, the UK/US exchange

rate changes by 0.00023% during weekend days and by 0.00047% on holidays. This can be

explained by the fact that trading volumes in weekends and holidays are significantly lower than

in regular days. Also, both independent variables have high p-values of 0.5239 and 0.6534,

respectively, which indicates that they are not statistically significant.

Finally, this regression had a reasonable R2 of 67.43% and all the independent variables

included in the model are statistically significant (have p-values < 0.01). Finally, one interesting

conclusion that can be drawn from this regression is that the coefficient for changes in UK

inflation was much higher than the coefficient for changes in US inflation.

6. Forecasting Model (Refer to Exhibit 7)

Finally, we decided to test our best regression model by using it to forecast the UK/US

exchange rate for the year of 2012 and, then, comparing it to the actual exchange rates values

observed at the end of each month of 2012. In order to forecast the exchange rate for each month

of 2012 we plugged in the data for each independent for the previous month (for example, to

forecast January 2012 we used data from December 2011) into the regression. The next step was

to calculate the actual percentage change in exchange rates observed in each month and compare

it to the expected percentage change, which was calculated by comparing the predicted value for

one month to the actual value observed the prior month. Finally, we calculated the percentage

change differences between the actual and predicted exchange rates. Even though the average

percentage difference between our forecasted model and the actual rates was only 1.17%, our

model failed to predict the direction of change (whether the British pound would depreciate or

appreciate against the dollar) in 4 out of 12 months. It is possible to conclude that the model

needs improvement in order to be reliable in predicting future UK/US exchange rates. Its R2 of

69.47% could be improved with the testing of additional variables and removal of variables that

were not significant such as both UK and US Public Debt and US Unemployment.

7. Conclusion The UK/US exchange rate has been a major influencer in economic activity and has been

affected by a number of different factors. From 1972, we have observed the relationship between

the two currencies and explained why they moved in the manner that they have. We have given

historical reasoning and consolidated our understanding through running regressions against

various variables which we believed were the major influencers of the currencies. Our first two

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analyses were conducted to compare and contrast whether actual levels of certain variables would

give up a better result, or the percentage change. Our findings indicated that the actual levels gave

us a more accurate answer due variables such inflation and unemployment already being in a

percentage form. From the first regression we were also able to prove that inflation, interest rates

and unemployment in the UK and the US are significant giving us an R2 of 59.54%.

Using the variables from our first regression, we were able to select more macro-

economic indicators such as unemployment, trade balance, public debt and GDP in both

countries. Running the regression once again gave us a higher R2 69.47% helping us conclude

that these variables made a significant impact on the exchange rate. Overall, from our regressions,

we can forecast ahead and ascertain the extent of impact different macro-economic factors will

have on the UK/US exchange rate. Moreover, our results also show that no single factors can

accurately predict the UK/US exchange rate and therefore it requires great speculation and use of

various forecasting methods in order to get a somewhat close forecast. Our forecasted exchange

rates for 2012 were close to the actual rates with an average difference of 1.17% , however, it

failed to predict the direction of change in the exchange rate in 4 of the 12 tested periods.

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Exhibits Exhibit 1

Exhibit 2-‐ Regression 1- Levels in Inflation, Interest Rate, and Unemployment (all figures

are in pounds to dollars):

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Exhibit 3-‐ Regression 2- Changes in Inflation, Interest Rate, and Unemployment (all figures

are in pounds to dollars):

Exhibit 4 – Regression 3 - Changes in Inflation, Interest Rate, and Unemployment (all

figures are in pounds to dollars):

SUMMARY OUTPUT

Regression StatisticsMultiple R 0.317155796R Square 0.100587799Adjusted R Square 0.077226443Standard Error 0.023534456Observations 238

ANOVA

df SS MS F Significance FRegression 6 0.014308919 0.00238482 4.305734628 0.000388202Residual 231 0.127944113 0.000553871Total 237 0.142253032

Coefficients Standard Error t Stat P-‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -‐0.000545312 0.001554801 -‐0.350727504 0.726112421 -‐0.003608716 0.002518093 -‐0.003608716 0.002518093US Inflation -‐0.936440511 0.38214342 -‐2.450494921 0.015008994 -‐1.689372594 -‐0.183508428 -‐1.689372594 -‐0.183508428UK Inflation 0.468569656 0.577829668 0.810913115 0.418250257 -‐0.66992043 1.607059742 -‐0.66992043 1.607059742US Interest Rate -‐0.15383051 0.781830879 -‐0.196756759 0.84419089 -‐1.694261461 1.386600441 -‐1.694261461 1.386600441UK Interest Rate -‐2.71088911 0.893562389 -‐3.033799478 0.002691156 -‐4.471463165 -‐0.950315055 -‐4.471463165 -‐0.950315055US Unemployment -‐0.13799189 1.1005043 -‐0.125389687 0.900324109 -‐2.30630083 2.030317051 -‐2.30630083 2.030317051UK Unemployment 1.51912457 1.630354914 0.931775381 0.352425431 -‐1.693141966 4.731391107 -‐1.693141966 4.731391107

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Exhibit 5- Regression 3- Levels in Inflation, Interest Rate, Unemployment, Trade Balance,

Public Debt (as a % of GDP), and GDP Growth (all figures are in pounds to dollars):

Exhibit 6 - Regression 4- Changes in Inflation, Interest Rate, Dummy Weekend, Dummy US

Holidays (all figures are in pounds to dollars):

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Exhibit 7- Forecasting Results (all figures are in pounds to dollars):

Average of Differences between Actual and Predicted: -0.01574 or -1.17%

Date Actual FX Rate

Actual Change Expected

Expected Change

Difference Between Actual and Predicted

Percentage Change Differences

1/31/2012 0.63450 -‐0.36% 0.58636 7.92% -‐0.04814 8.28% 2/29/2012 0.62830 -‐0.98% 0.61961 -‐2.35% -‐0.00869 -‐1.37% 3/30/2012 0.62460 -‐0.59% 0.61800 -‐1.64% -‐0.00660 -‐1.05% 4/30/2012 0.61600 -‐1.38% 0.61906 -‐0.89% 0.00306 0.49% 5/31/2012 0.64910 5.37% 0.61585 -‐0.02% -‐0.03325 -‐5.40% 6/29/2012 0.63670 -‐1.91% 0.61168 -‐5.76% -‐0.02502 -‐3.85% 7/31/2012 0.63780 0.17% 0.61017 -‐4.17% -‐0.02763 -‐4.34% 8/31/2012 0.63030 -‐1.18% 0.60953 -‐4.43% -‐0.02077 -‐3.26% 9/28/2012 0.61850 -‐1.87% 0.61207 -‐2.89% -‐0.00643 -‐1.02% 10/31/2012 0.62000 0.24% 0.61224 -‐1.01% -‐0.00776 -‐1.25% 11/30/2012 0.62450 0.73% 0.61619 -‐0.61% -‐0.00831 -‐1.34% 12/31/2012 0.61540 -‐1.46% 0.61612 -‐1.34% 0.00072 0.12%

Average -‐0.01574 -‐1.17%

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