1. Web Problem: Go to www.oanda.com/currency/ big-mac-index. Oanda reports the last available Big Mac index but then updates the exchange rates on a regular basis to compare them with the PPP-based exchange rates. What are currently the most undervalued and overvalued exchange rates? How would you use this information in forecasting exchange rates?
2. Mini Case: Valuing Currency Management: TOM Versus U.S. Commerce Bank
On February 19, 2009, an arbitral tribunal found that U.S. Commerce Bank (USCB) Analytics, a wholly owned subsidiary of USCB Corporation, a large U.S.-based bank, had breached an exclusivity provision of its joint venture (JV) agreement with Trend Ontledings Maatschappij (TOM), a Dutch currency management business. Consequently, TOM claimed USCB was obligated to compensate the firm for lost earnings that would have accrued to TOM during the life of the JV.
Exhibit: Zooropa in Numbers
|
Country
|
Currency's C CRLS Position U
|
urrency's Over, ndervaluation %
|
Reserves, Import Coverage
|
Budget Deficit as
% of GDP
|
Inflation Rate, %
|
GDP Growth,
%
|
|
Sinead
|
- 6
|
- 10
|
9
|
- 1.9
|
3.6
|
2.4
|
|
Carmen
|
- 36
|
- 12
|
3.1
|
- 2.3
|
2.7
|
2.0
|
|
Marquee
|
16
|
11
|
8.2
|
- 4.9
|
5.7
|
2.0
|
|
Fries
|
- 3
|
11
|
11.7
|
- 5.4
|
9.5
|
2.8
|
|
Ney
|
- 22
|
- 2
|
2.5
|
- 2.1
|
2.2
|
2.1
|
|
Helpisink
|
31
|
- 18
|
1.3
|
- 5.5
|
2.1
|
1.6
|
|
Benfica
|
30
|
- 16
|
1.5
|
- 3.4
|
3.5
|
1.6
|
|
Che ora
|
- 90
|
3
|
2.6
|
- 4.6
|
3.6
|
- 0.8
|
|
Vachement
|
27
|
2
|
0.5
|
- 11.3
|
5.2
|
1.3
|
Notes: The CRLS position measures the general strength or weakness of a currency within the target zone. A value of -100 means that the currency is at its lower bound and is weak relative to all other currencies in the zone. A value of 100 means that the currency is at its upper bound and is strong relative to all other currencies in the zone. The currency's over->undervaluation is relative to the prediction of purchasing power parity (PPP). It is computed by taking the percentage deviation from the prediction of PPP of the currency versus the banshee, the central rate in the system. A positive number means the currency is overvalued relative to PPP. Import coverage calculates the ratio of foreign exchange reserves at the central bank to average monthly imports. This indicates how many months of imports could be purchased by the foreign exchange reserves held at the central bank. The inflation rate and GDP growth rate are in percentage per annum.
Established in 2006, the JV was to last for a minimum of 4 years. USCB was responsible for marketing the JV to third-party clients including central banks, institutional investors, and corporate clients. TOM was responsible for providing the investment management expertise by delivering a low-return, low-volatility, alpha currency investment product. TOM had a long history of quantitative trading in the currency markets. In the 1970s, TOM was thought to be the first firm to apply computerized trading to exchange rate markets. Successful partnerships with a number of U.S. banks in the 1980s and early 1990s made Geert Rijkaard, TOM's founder, one of the richest men in the world. Because the firm's strategy focused on European currencies relative to the dollar, the arrival of the euro in 1999 led to a suspension of TOM's trading activities. However, after adapting its models to focus on the euro> dollar pair, TOM started trading again in 2004 and began actively looking for partners that could help market the product.
However, as a result of the contract breach, TOM had terminated the JV on July 30, 2007. TOM claimed that it was owed in excess of $300 million from USCB. Both parties assembled teams of experts to make their cases to the tribunal. The tribunal would then use the information provided by these experts as the basis for making a decision as to the amount of damages owed to TOM.
Although all names used here are fictitious, the story is based on a real-world case. A Columbia CaseWorks case written by Bekaert (2011) provides more details. It lays out the analysis by TOM's team to motivate the $300 million damages number, relying largely on the detailed busi- ness plan at the time the JV was formed. The case further describes several key exhibits assembled by USCB's team. Its first task at hand was to simply figure out what kind of currency manager TOM was: Does it follow trends, trade on fundamentals, or run a carry strategy? The team also believed it would be important to study the relative investment performance of the JV and did so using actual data from the Barclay Currency Traders Index. Given the large number of currency funds that were available to investors, the JV's ability to win clients and grow its AUM would undoubtedly be closely linked to its performance, both in absolute terms and relative to other currency funds. Finally, simply generating a plausible track record of returns suitable for use in projections raised interesting issues. For example, TOM's team had resorted to using paper returns (meaning returns from a trading strategy that had not been used in actual trading yet) to pull together a long return record. To learn more about this case, please go to www4.gsb.columbia.edu/caseworks/ and look for the Valuing Currency Management case.