Tower Associates Case Analysis

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For example, in country A for year 2003, the exchange rate based on PPP was calculated at 3.961293local currency units per 1 USD, whereas the actual spot exchange rate was 2.888 local currency units per 1 USD. Therefore it is implied that in year 2003, country A’s currency was overvalued.

By exhibit 2 we can conclude that the PPP theory does not hold for the currencies of these countries during the given period examined.

- Calculation of International Fisher Effect (Please refer excel sheet – Exhibit 3)

To calculate International Fisher Effect (IFE) theory held between the exchange rates of Countries A to D and the US dollar between 2002 and 2007, the following steps are followed:

First the annual US dollar lending rates were found from the World Bank website. Given the annual local lending rates and each year’s actual (spot) exchange rate, the expected next year’s exchange rate was calculated based on the IFE theory:

Forward Exchange Rate (Y 2003) = [Spot Exchange Rate Y 2002 x (1 + Local Lending Rate Y 2003) ] / (1 + US Lending Rate Y 2003)

For example, forward rate in year 2003 for country A was calculated as follows: [3.533 x (1+67.08%)] / (1+4.12%) = (3.533 x 1.6708) / (1.0412) = 5.669

The direct quotation method was used for the exchanges rates (USD/LC) implying local currency units per 1 foreign currency unit (USD).

Exhibit 4 gives us further more details about IFE whether the currency is over or undervalued. If the difference is positive, it is overvaluation and if the difference is negative, then it is undervaluation.

For example, in country A for year 2003, the IFE (implied) exchange rate was calculated at 5.669 local currency units per 1 USD, whereas the actual spot exchange rate was 2.888 local currency units per 1 USD. Therefore it is implied that in year 2003, country A’s currency was overvalued.

- Conclusion in which country should Tower Associates invest

Based on the PPP and IFE calculations above in country A, B, C local currencies were over-valued as compared to their implied exchange rates based on PPP and IFE theories. The currencies of countries A, B and C were likely to experience a significant depreciation in their values in the next five years, whereas country D’s currency was more aligned to its implied exchange rates.

Even though country D - China was also over valuated but there is no major difference when compared to other countries. So, we recommend Tower associates to invest in China.

Additional Note:

Inflation rate is measured by Consumer Price Index. 2002-2003 is considered the base year for price appreciation with index value at 100. Inflation takes place when supply is not able to match up demand.

- An ideal inflation Rate is about 3-4%.

- Higher inflation rate above 6% are considered dangerous.

- Lesser rates below 1-2% are signs of slowdown in the economy.

References:

http://www.inflation.eu/inflation-rates/united-states/historic-inflation/cpi-inflation-united-states.aspx

http://data.worldbank.org/indicator/FR.INR.LEND?page=2