Ways of expressing forward rates

In addition to the direct or indirect quotation, forward exchange rates can be expressed in one of three ways. First, the forward rate can be quoted as an outright rate — i.e. the actual forward rate of exchange.

Secondly, it can be quoted as forward exchange margins or points (also called swap rates). These latter are either discounts or premiums depending on the interest differentials between the home and foreign currency. If the foreign currency interest rate is higher than the home currency interest rate, the foreign currency will be at a forward discount to its spot rate. If, on the other hand, the foreign interest rate is below the home currency interest rate, the foreign currency will be at a forward premium to its spot value. The magnitude of the discount or premium is dependent upon the size of the differential in home and foreign interest rates and the time to maturity of the forward contract. Read more »

Posted: June 24th, 2008 under Currency Futures, Foreign Exchange Futures, Futures Market.
Comments: 5

The foreign exchange market is an interbank market, in that there is no designated market-place; instead transactions are conducted over the telecommunications system using telephones and computer screens. As a consequence, the foreign exchange (or FX) market is truly global, with all the major commercial banks around the world and the treasury departments of many companies participating. In addition, central banks enter the market in the execution of their monetary and exchange rate policies. There is also a system of brokers who act as intermediaries to supplement the direct contact between participants. As the trading day progresses, the centre of activity moves from one time zone to another, making it possible t trade internationally 24 hours a day.

The transactions in the FX market emanate from international trade, international investment, the hedging of exchange risks, the establishment of speculative positions or arbitraging between mispriced sections of what is a vast market. Read more »

Posted: June 24th, 2008 under Currency Futures, Foreign Exchange Futures, Future Exchange, Future Trading.
Comments: 4

A US investor has purchased Sterling Treasury bills and wishes to hedge against the falling value of Sterling. Buying the out-of-the-money put (strike price $1.8500) will protect against a fall below that figure. The sale of the out-of-the-money call at $1.8900 will mean that the investor will benefit from any rise in Sterling to $1.8900 but not above that figure. The cost of buying the put is off-set by the revenue from writing the call, resulting in this instance in a zero cost strategy.

The reader will note that if Sterling rises above $1.8900, the written call position will make a loss. This is off-set by the rising value in dollar terms of the underlying Sterling investment. Conversely, if Sterling falls below $1.8850, the puts make a profit which off-sets the currency losses on the investment in the Sterling Treasury bills. Read more »

Posted: June 22nd, 2008 under Commodities Futures, Currency Futures, Equity Futures, Future Fund, Futures Contracts, Futures Options, Futures Spreads, Futures Trader, Futures Trading System, Managed Futures, S&P Futures.
Comments: 4

The Black model should not be used for valuing American options on currency futures because it may be optimal to exercise the options early in the same way as it may be optimal to exercise options on the spot currency early. The binomial or the Barone-Adesi and Whaley models may be used for valuing those options.

The early exercise potential of American options on futures is different to that of options on the spot. Futures prices do not exhibit the discrete jumps that accompany spot market assets when the underlying spot asset makes discrete distributions. However, as the carry basis of the future converges to zero at delivery, the futures price converges to the spot price in an orderly manner. Read more »

Posted: June 22nd, 2008 under Currency Futures, Futures Options, Futures Prices, Swap Futures, investment.
Comments: 4

Term structure based option-pricing models

Term structure models of pricing contingent claims have followed one of two approaches. One approach followed by Cox, Ingersoll and Ross (1985) actually model the expected returns from movements in the term structure in order to price the contingent claims. In effect, the term structure becomes endogenous to the pricing of the contingent claim.

The second approach followed by Ho and Lee (1986), Heath, Jarrow and Morton (1989), Black, Derman and Toy (1990) and Hull and White (1990) utilizes the volatilities of the various sectors of the term structure to derive a probability distribution of an arbitrage-free binomial, trinomial or multinomial lattice of the term structure. From this lattice, contingent claims are priced. These models all have one thing in common: they allow for the whole-term structure to be stochastic instead of the price of a single underlying instrument or a single interest rate. The whole-term structure is represented at each node of the binomial, trinomial or even multinomiaf lattice. Read more »

Posted: June 15th, 2008 under Currency Futures, Future Fund, Future Management, Future Trading, Futures Index, Futures Market, Futures Prices, Futures Spreads, Futures Trader, Futures Trading System, Managed Futures, S&P Futures, Stock Futures, investment.
Comments: 3

A detailed analysis of the empirical testing of the term structure is beyond the scope of this post; however, in summary it should be stated that the empirical tests give a substantial role to expectations. However, forward rates are not unbiased estimators of future spot rates, and the bias is consistent with a liquidity premium. There is also some evidence that the premium increases with the term to maturity, but at a decreasing rate. There is less support for the segmentation hypothesis.

The dynamics of the term structure

Clearly the term structure is dynamic, but exactly what is the nature of this dynamic process? It has long been observed that long rates are less volatile than short rates; for further discussion see Kessel (1965), Malkiel (1966) and Brooks and Livingston (1990). Current long-rate volatilities are linked to current short-rate volatilities by the concept of mean reversion — i.e. where short rates have a tendency to be pulled back towards some long-term average value following a movement up or down. Read more »

Posted: June 15th, 2008 under Currency Futures, Future Exchange, Futures Contracts, Managed Futures, Swap Futures.
Comments: 4

However, this theory of the development of the swaps market assumes that the financial markets remain informationally inefficient and that the benefits of comparative advantage are not arbitraged away. There is no doubt that in the early days of the interest rate and currency swaps markets it was possible to locate such inefficiencies that resulted in generous benefits to both parties, but in the years since the market’s inception the benefits have to some extent been reduced by arbitrage, yet the market still grows dramatically.

Thus there must be some other reason, or reasons, for the existence of the swaps market as the comparative advantage theory assumes that some markets persistently underprice credit risk relative to other markets. Three alternative reasons for the market’s existence can be postulated. Read more »

Posted: June 14th, 2008 under Currency Futures, Foreign Exchange Futures, Future Exchange, Future Investing, Future Management, Future Trading, Interest Rate Futures, Managed Futures, Stock Futures, Stock Market Futures, Swap Futures.
Comments: 4

Key Points

• When currencies are exchanged for delivery more than two business days later, the governing exchange rate is the forward rate. The forward rate is given by an inviolable interest rate parity that ensures that two riskless investments generate the same total return. Under normal circumstances, the forward rate should be an unbiased predictor of the future spot rate. However, the actual future spot rate is significantly different from the forward rate. This phenomenon is referred to as the forward rate bias.
• In order to satisfy the requirement of the same return generated by two riskless assets given by interest rate parity, the currency with the higher interest rate must depreciate relative to a currency with a lower interest rate as given by the forward rate. Evidence indicates that the currency with the higher interest rate actually appreciates instead of depreciating. This pattern is confirmed for a variety of currency pairs not including high-interest-rate currencies, for many different observation periods, and many different holding periods. It seems that the bias decreased a little during the 1990s and it disappears when the holding period becomes about ten years. However, the bias at short holding periods of about one month is of most interest to investors.

Read more »

Posted: February 14th, 2008 under Currency Futures.
Comments: 4

If you understand the basic principles of hedging and speculating, you will have no trouble applying those concepts to futures contracts on foreign currencies.

Hedging and Speculating with Foreign Currency Futures

We have seen that with the appropriate hedging strategy, farmers can reduce price risk. In the world of international business, another significant risk is foreign exchange risk, or the risk of loss due to shifting relative values in national currencies. The next two chapters will discuss how the futures market enables a portfolio manager to minimize market risk and how bankers can reduce the interest rate risk they face. Read more »

Posted: February 3rd, 2008 under Currency Futures, Futures Contracts, Futures Market, Futures Prices.
Comments: 4

Collapse of the Bretton Woods Agreement

Up to the First World War, the world’s currencies were described either as hard or soft currencies, depending on whether they were convertible into gold at a fixed or floating exchange rate.

In 1945, after the Second World War, the Bretton Woods Agreement was reached and was responsible for keeping a narrow band of fluctuation (2 per cent) between the US dollar, which was pegged and convertible into gold, and other currencies.

By the 1970s it had become impossible to keep so many currencies, each from countries with completely different economic growth rates, within the agreement, and so in 1972 it was abandoned. Read more »

Posted: January 26th, 2008 under Commodities Futures, Currency Futures, Future Exchange, Future Trading, Futures Contracts, Futures Market.
Comments: 3