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

Average rate currency options are based upon the average exchange rate of the underlying currency as distinct from the exchange rate on a single date — the expiry date.

The advantage of an average rate option is that the volatility of a moving average of a variable is less than the volatility of individual observations of that same variable. With daily observations, and with the volatility levels seen in the currency markets, the volatility of the moving average is in the order of 60% of that of the raw observations. Consequently, the price of an average rate option with a given exercise price will be less than an otherwise identical standard European currency option. Read more »

Posted: June 21st, 2008 under Equity Futures, Future Market Trends, Futures Market, Futures Options, Futures Spreads, S&P Futures, Stock Market Futures, Swap Futures, investment.
Comments: 5

It was shown that it is possible to lock in a forward rate of interest. However, depositors will only lock in a forward deposit if the rate that results is at least as favourable as the rate that they expect to prevail at the future point in time. If the forward rate implied by the current rates was above investors’ expectations, theinvestors would increase their borrowing for 90 days, causing upward pressure on that rate, and increase their deposits for 180 days, causing downward pressure on that rate, thereby bringing the 90-day forward rate down to current expected levels.

Conversely, if the implied forward rate were below expectations, investors would borrow for the longer term, raising that rate, and deposit for the shorter term, lowering that rate, until the implied forward rate matched expectations. Read more »

Posted: June 20th, 2008 under Future Exchange, Futures Contracts, Futures Market, Futures Prices, Interest Rate Futures.
Comments: 6

Basket options are not new, for equity index options are a form of basket option. However, basket options relating to currencies are only available (at the time of writing) from the OTC market. The one exception is the ECU option traded on the Philadelphia Stock Exchange.

Currency basket options, like equity index options, are options on portfolios of specified currencies. As such they are appropriate for managing the currency risk inherent in the cash flows generated in a variety of currencies. An example would be the monthly remittance of income from a variety of foreign currency bond holdings. Read more »

Posted: June 19th, 2008 under Futures Market.
Comments: 4

The investment manager may have a number of bond-like assets in the portfolio, and corporate treasurers may have issued similar liabilities which have options embedded within them by virtue of the contract terms under which the bonds were issued. Common examples of such bonds are as follows.

• Bonds with call provisions allow the issuer to call the issue at a date earlier than the redemption date, at a price different from par but specified when the bond is issued. Bonds with sinking funds attached also have an embedded option.

• Putable bonds give the holder the option to put the bond back to the issuer at a predetermined price.

• Convertible bonds give the holder the option of converting the bond into the equity of the issuer. The rate of conversion and the time is specified when the bonds are issued. Some convertible bonds have been issued that provide for conversion into other bonds.

Read more »

Posted: June 15th, 2008 under Futures Options, Swap Futures.
Comments: 6

Currency swaps, which were developed before interest rate swaps, were derivations of the 1970s practice of establishing parallel loans between two parties whereby, for example, company A would lend its domestic currency to company B, in return for a loan of company B’s domestic currency. These parallel loans were often used to manage exchange risk or to circumvent exchange control regulations.

This system of mutual lending had two serious drawbacks. First, there was no automatic off-set of the cash flows between parties. Thus, if company A defaulted on its loan from B, company B would still have to honour its commitment to A. Secondly, although the two loans effectively cancelled each other out, they were still shown on the balance sheets of each company. Read more »

Posted: June 14th, 2008 under Commodities Futures, Crude Oil Futures, Equity Futures, Future Exchange, Future Fund, Future Investing, Future Management, Future Trading, Futures Contracts, Managed Futures, Swap Futures.
Comments: 3

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.

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

Selling Offshore Funds in Germany

This is governed by the Foreign Investment Fund Act of 1969 (the Act) which applies to funds whose shares are distributed to the public, in its widest sense, in Germany and which invest in securities or real estate with the aim of spreading investment risk.

As a result an offshore fund which invests in futures, and options and is specifically excluded from investing in securities or real estate falls outside the Act. This means that an offshore managed futures fund can be sold widely in Germany as long as it complies with the domestic marketing rules laid out in the Act against Unfair Competition.

`Securities‘ are not defined in the Foreign Investment Fund Act but are interpreted, under general principles, as meaning ‘transferable certificates’ of any sort. Thus, it is not the nature of the underlying instruments but the nature of the document representing the relevant instrument which needs to be considered. Since German futures contracts are not in fact transferable (because the contracts are traded on a back-to-back basis as in the US and the UK), they would not be considered to be securities. Read more »

Posted: February 7th, 2008 under Future Fund, Futures Contracts.
Comments: 3