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A Forecast of the Usd/jpy Exchange Rate

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EUROPEAN SCHOOL OF ECONOMICS

A forecast of the USD/JPY Exchange Rate

Multinational Financial Management - Prof N.Gandevani

Filippo Bonfiglio

MBA 2011 - 2012

Contents

1. Executive Summary 1

2. Overview of the Forex Market 1

3. The USD/JPY exchange rate: a brief overview of its movement 1

4. Fundamental Analysis 2

4.1. Inflation 3

4.2. Interest rate 5

4.3. Income Level 8

4.4. Government Control 8

4.5. Expectation 8

5. The Purchasing Parity Power 8

6. The Interest Rate Parity 8

7. The International Fisher Effect 8

8. Final Considerations and Conclusions 8

9. References 8

Executive Summary

The aim of this paper is to analyze the historical fluctuation of the exchange rate between the US Dollar and the Japanese Yen in order to come out with estimation of the value that the exchange rate will reach in one year.

In order to make this estimation we started with a fundamental analysis understanding which variables can affect it and the trend which has been identified as depreciating.

The results of the analysis had then been proved through the application of the Purchasing Power Parity, the Interest Rate Parity and the International Fisher effects with the aim of calculating an approximate value.

As a result we reached to a depreciation that should be within 0 and 1.4%.In particular applying the PPP theory I estimated the future value of the USD/JPY rate as 78.70392

Overview of the Forex Market

The forex market is the largest financial market with daily average transactions for more than 3 trillion USD (Eun & Resnick, 2007). The aim of the market is simply providing people purchasing power in foreign countries, which means the possibility to develop international businesses. The transaction are basically represented by spot operations with the immediate purchase from one party of a foreign currency and the simultaneous sale from another, and by forward operations, in which today the parties contract the future transactions defining when and at what price it will be concluded.

The currencies bought and sold can be divided in base currencies and exotic currencies on the basis of the volume and value of transactions performed.

The USD/JPY exchange rate: a brief overview of its movement

From 1972 to date the trend of the exchange rate between US Dollar and Japanese Yen is decreasing, with the highest decreasing rate in the second half of the 80ies.

Figure 1: Historical data USD/Japanese Yen (www.tradingeconomics.com)

In the last 12 months we assist to a decrease around September and a stable value until the end of February, an increase in March and another decrease in the last two months.

Figure 2: The US Dollar / Japanese Yen in the last 12 months (www.tradingeconomics.com)

Fundamental Analysis

In order to foresee the future value of the exchange rate between the US Dollar and the Japanese Yen we are using the fundamental analysis with the aim of foreseeing the possible future evolution of the two currencies. The variables considered, in particular are the following:

The Inflation rate: an increase of the inflation rate in one country, considering stable all the other variables will make the currency of that country depreciate as per the decreasing demand of the currency itself.

The interest rate: considering stable all the other variables, an increase of the interest rate in a country will automatically attract foreign investors, with a consequent increase in the demand of the currency, and the following appreciation of the exchange rate.

Relative income: considering stable all the other variables an increase of the income in a country determines an increase in imports, and the consequent demand of foreign currency with a depreciation of the local.

Government Control and Political Stability: considering stable all the other variables a change in terms of politics from a liberal to a controlled economy will decrease the appealing of investing into a country. In addition the risk of revolution or political instability can cause a higher level of uncertainty and work as a dissuasion for foreign investments with a decrease of the demand of the currency. Furthermore a country with a government not tied by international agreement and that can with monetary policy sustain or generally influence the currency cause uncertainty on the exchange rate, so a loss in term of appealing from foreign investors.

Expectation: also the expectations can affect the value of the exchange rate, because "like other financial market, foreign exchange market react to any news that may have a future effect" (Madura, 2009)

Inflation

The Inflation rate trend in japan from 1971 is about 2.8%, with an incredibly high moment in 1974 when the inflation reached 24.9% during February, and its lowest moment in October 2009 when it reached a deflation of -2.5%.

Figure 3: 20 years Japanese inflation rate data (www.tradingseconomics.com)

The value in April 2012 is around 0.5%, and generalizing we can affirm that in the last 20 years, if we exclude some moments in which it raised up to 3% and went down more or less of the same amount, The country has a low level of inflation, with an average below 1%

Figure 4: 12 months Japanese Inflation rate data (www.tradingeconomics.com)

The United States historically has an average inflation rate around 3.4% with a maximum reached in June 1920 and a record deflation around -15.8% one year

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