INTERNATIONAL FINANCIAL MARKETS

Assignment #5: Currency Value Fund

Professor Amir Yaron
FNCE-219
Due: April 21
st
, 2014

Wisdomteeth is a company that markets ETFs (exchange traded mutual funds). Shares of an ETF
are traded on a stock exchange like regular stocks. Wisdomteeth already offers a number of
funds that allow investors to take positions in individual countries money markets. They are
now interested in offering additional FX funds. In particular, they are considering a Currency
Value Fund.

Value investing has a long tradition in equity markets. Based on measures that capture the
fundamental value of a stock, such as earnings or book values, positions are taken in stocks as a
function of how over- or undervalued the current price is relative to such measures. Academic
research on currencies has shown that fundamentals are not good forecasters for the short and
medium term; however, they seem to work for the long term. In particular, Purchasing Power
Parity (PPP) has been documented as having strong predictive power for the long run.

Europa Bank (EB), one of the leaders in the foreign exchange market, has recently introduced an
ETF, called Europa Bank Value (EBV) that selects currency long and short positions based on
PPP. This fund uses a set of simple rules to decide how much to invest (long or short) in each
currency. They believe that investors prefer such transparent management of the fund, rather
than picking investments on a more discretionary basis. Wisdomteeth would like your consulting
input about this fund and about designing a Currency Value Fund more generally. An Excel data
file has been prepared for that purpose and is available on the class webpage.
1. Promotional material. To illustrates PPP at work, produce a graph for the evolution of the
CAD/USD spot and PPP values over the given sample period (like the graphs given in the lecture
notes). You will have to scale (multiply) the PPP values by a constant so that average level of the
PPP exchange rate equals the average level of the actual spot rate. When is the CAD overvalued
and when is it undervalued? For the Summer/Fall 2011, what should the PPP value of CAD/USD
be? How does that compare to the most recent PPP value given by the OECD (as given in the
class lecture notes #9 on PPP)?

2. Composition of the fund. EBs fund follows some mechanical rules. The fund is rebalanced
once a year based on the spot rate of the end of the year and the most recently available PPP
value in the following way:

(1) Define the currency pool, the 10 major currencies: USD, EUR, GBP, CHF, J PY,
AUD, NZD, CAD, SEK, NOK.

(2) Rank the spot rate (defined as FC/USD) at the end of the year divided by the most
recent Purchasing Power Parity rate. The Purchasing Power Parity rate is the
equilibrium value for each currencys spot exchange rate versus the USD as published
annually every March by the OECD.

(3) The fund consists of long the 3 currencies with the highest rank against short the 3
currencies with the lowest rank, all equally weighted. This creates a long exposure to the
currencies which are trending higher, and a short exposure to the currencies that are
trending lower.

A. Based on the data available, what is the composition of the fund for 2010, based on the spot
rate at the end of 2009, and the most recently available PPP value (which is the 2008 value given
in the file)?

B. Over the last 5 years, how many times was each currency short or long? (You may use
Excels Sort command).

C. Wisdomtheeth would like to consider alternative selection criteria. In particular, they would
want to select currencies based on the percentage change in the real exchange rate over the
previous 5 year period. That is, instead of sorting currencies based on the ratio S / Sppp, as in A.,
they want to sort them based on the growth rate of this this ratio over the last 5 years. Assuming
that they also want 3 short and 3 long positions, what would be the composition of the fund for
2010? Over the last 5 years how many times was each currency short or long? How does the
composition compare to the fund computed in A. and B.?

D. What are potential advantages and disadvantages of these two approaches?

3. Return behavior of the fund (EBV Europa Bank Value) compared to US stock and
Money Market (MM) investments. Based on the total return indexes I(t) given, compute
monthly returns as R(t,t+1) =I(t+1)/ I(t) -1.

Report mean returns. Report mean and standard deviations of excess returns (defined as returns
minus the Money Market return), as well as the Sharpe Ratios, (mean divided by standard
deviation of excess returns).

Compute the biggest monthly gain and biggest monthly loss. Compute the correlation between
excess returns of the EBV and US stocks for the entire sample period, and over the last 3 years of
the sample.

What features of the EBV fund returns do you find attractive?

4. Dynamic investment strategy. Extensive further data analysis suggests that the EBV fund
returns should exhibit lengthy periods of average performance with occasional periods of sharp
positive returns when valuations jump back to long term equilibrium values quickly after
prolonged periods of slowly drifting way from these equilibrium values.

Briefly comment. To take advantage of this behavior, when should the fund increase or reduce
the overall size of its currency positions? What type of simple rule could implement this?
These should be qualitative answers.