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European Euro Project 4

European Euro Project 4. Danielle Gardner Donna Zviely Garrett McCulloch. Asset Choice Model. Relative interest rates: Higher short term and long term rates in Europe than most other major currencies Expected to attract foreign investment Dollar depreciates and Euro appreciates

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European Euro Project 4

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  1. European EuroProject 4 Danielle Gardner Donna Zviely Garrett McCulloch

  2. Asset Choice Model • Relative interest rates: • Higher short term and long term rates in Europe than most other major currencies • Expected to attract foreign investment • Dollar depreciates and Euro appreciates • Safe Haven Effect: • will strengthen Euro if investment flees from US to an alternate stable currency • Political/country risk: • low political risk and country risk in the euro zone. • Carry Trade Strategies: • speculators buy high interest currencies and sell currencies with low interest rates, thus investors may purchase the Euro which has a higher interest rate than most, creating upward pressure on the currency and increase demand for the Euro • Unemployment is 9.2% in Europe, while 9.1 % in US • Current Account in EUR is -25; US Current-account deficit decreased $53.4 billion to $101.5 billion in Q1 2009 • Growth rate in EUR is -4.8% while Q1 2009 -5.5% • Slowing rate of contraction • In conclusion, the 3-month and 6-month spot rates will increase slightly against the USD. We predict a rate of $1.42 for 3-month spot, and $1.44 for the 6-month spot rate. http://www.usatoday.com/money/economy/2009-05-07-slow-us-economic-growth_N.htm www.bloomberg.com

  3. Purchasing Power Parity Model Assume: • Spot EUR/USD: 1.4096 (as of June 26, 2009) • Forecasted EUR rate of inflation for the next 12 months: 1.6% • Forecasted US rate of inflation for the next 12 months: 1.3% • Anticipated inflation rate differential = .3% PPP Spot EUR/USD Forecast: • 1 year change in EUR: 1.4096 x 0.003 = 0.0042 • 3 month spot EUR: 1.4096 - 0.0042/4 = 1.4086 • 6 month spot EUR: 1.4096 - 0.0042/2 = 1.4075 http://forecasts.org/inflation.htm http://www.eui.eu/RSCAS/Research/EFN/EFN2009_spring.pdf

  4. International Fisher Effect Assume: • Spot EUR/USD = $1.4096 • Current 3 month ECB rate = 0.596% • Current 6 month ECB rate = 0.601% • Current 3 month US Govt Bond rate = 0.15% • Current 6 month US Govt Bond rate = 0.09% • Differential 3 month = 0.596 – 0.15 = 0.446% • Differential 6 month = 0.601 – 0.09 = 0.511% • Spot rate x differential = 3 month change = 1.4096 x 0.00446 = 0.0063 • Spot rate x differential = 6 month change = 1.4096 x 0.00511 = 0.0072 IFE Spot EUR/USD: • 3 month Spot EUR = 1.4096 – 0.0063 = 1.4033 • 6 month Spot EUR = 1.4096 – 0.0072 = 1.4024 http://www.ecb.int/stats/money/yc/html/index.en.html#data http://www.moneycafe.com/markets/interestrates.htm?qm_target_page=Rates

  5. Comparison Table Our Choice: For both the 3-month and 6-month rates, we will choose the PPP model. These rates are neither the highest nor lowest, so we are being conservative with the middle selection

  6. Advice to MNC: open short • MNC open short: 3-month spot rate with the PPP model is $1.4086. 6-month = 1.4075. • This MNC is paying debt off in euro or making a euro denominated purchase, so they should not hedge with a futures contract because dollar-equivalent-costs will become lower in the future.   • The euro is depreciating against the dollar from $1.4096 to $1.4086 so a hedge would be detrimental to the financial value of the American based MNC. The same holds for the 6-month spot rate, because the euro will further depreciate against the dollar according to the PPP model that we have chosen.  

  7. MNC- open long • MNC open long: 3-month spot rate with the PPP model is $1.4086. 6-month = 1.4075. • This MNC is receiving euro, most likely from conducting business in the euro zone, so we will advise them to lock in a forward rate now, to assure a higher USD-equivalent-value than would be attained without the contract. • Since the euro will depreciate against the USD, the firm receiving euro will gain higher cash flows by locking in a forward contract with the current exchange rate of $1.4096. The euro is not expected to depreciate enough to use an options contract and pay the premium.

  8. Appendix Euro Bond rates

  9. Appendix

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