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FORWARD PREMIUM

The forward premium arises due to interest differentials between two currencies. In order that the two currencies have the same intrinsic values as they have today and avoid interest arbitrage, the premium/discount

comes into effect. The forward rate includes the forward premium/discount and so the risk of spot market

moving

in

the

wrong

way

is

OUTRIGHT FORWARDS

minimized

by

entering

into

a forward contract.

An outright forward transaction, like a spot transaction, is a straightforward single purchase/ sale of one currency for another. The only difference is that spot is settled, or delivered, on a value date no later than two business days after the deal date, while outright forward is settled on any pre-agreed date three or more business days after the deal date. Dealers use the term “outright forward” to make clear that it is a single purchase or sale on a future date, and not part of an “FX swap.”

There is a specific exchange rate for each forward maturity of a currency, almost always different from the spot rate. The exchange rate at which the outright forward transaction is executed is fixed at the outset. No money necessarily changes hands until the transaction actually takes place, although dealers may require some customers to provide collateral in advance.

Outright forwards can be used for a variety of purposes—covering a known future expenditure, hedging, speculating, or any number of commercial, financial, or investment purposes. The instrument is very flexible, and forward transactions can be tailored and customized to meet the particular needs of a customer with respect to currency, amount, and maturity date. Of course, customized forward contracts for nonstandard dates or amounts are generally more costly and less liquid, and more difficult to reverse or modify in the event of need than are standard forward contracts. Also, forward contracts for minor currencies and exotic currencies can be more difficult to arrange and more costly.

Outright forwards in major currencies are available over-the-counter from dealers for standard contract periods or “straight dates” (one, two, three, six, and twelve months); dealers tend to deal with each other on straight dates. However, customers can obtain “odd-date” or “broken-date” contracts for deals falling between standard dates, and traders will determine the rates through a process of interpolation. The agreed-upon maturity can range from a few days to months or even two or three years ahead, although very long-dated forwards are rare because they tend to have a large bid-asked spread and are relatively expensive.

Relationship of Forward to Spot—Covered

Interest Rate Parity The forward rate for any two currencies is a function of their spot rate and the interest rate differential between them. For major currencies, the interest rate differential is determined in the Eurocurrency deposit market. Under the covered interest rate parity principle, and with the opportunity of arbitrage, the forward rate will tend toward an equilibrium point at which any difference in Eurocurrency interest rates between the two currencies would be exactly offset, or neutralized, by a premium or discount in the forward rate.

If, for example, six-month Euro-dollar deposits pay interest of 5 percent per annum, and six-month Euro-yen deposits pay interest of 3 percent per annum, and if there is no premium or discount on the forward yen against the forward dollar, there would be an opportunity for “round-tripping” and an arbitrage profit with no exchange risk. Thus, it would pay to borrow yen at 3 percent, sell the yen spot for dollars and simultaneously resell dollars forward for yen six months hence, meanwhile investing the dollars at the higher interest rate of 5 percent for the six-month period

This arbitrage opportunity would tend to drive up the forward exchange rate of the yen relative to the dollar (or force some other adjustment) until there were an equal return on the two investments after taking into account

the cost of covering the forward exchange risk. Similarly, if short-term dollar investments and short-term yen investments both paid the same interest rate, and if there were a premium on the forward yen against the forward dollar, there would once again be an opportunity for an arbitrage profit with no exchange risk, which again would tend to reduce the premium on the forward yen (or force some other adjustment) until there were an equal return on the two investments after covering the cost of the forward exchange risk. In this state of equilibrium, or condition of covered interest rate parity, an investor (or a borrower) who operates in the forward exchange market will realize the same domestic return (or pay the same domestic cost) whether investing (borrowing) in his domestic currency or in a foreign currency, net of the costs of forward exchange rate cover.

The forward exchange rate should offset, or neutralize, the interest rate differential between the two currencies. The forward rate in the market can deviate from this theoretical, or implied, equilibrium rate derived from the interest rate differential to the extent that there are significant costs, restrictions, or market inefficiencies that prevent arbitrage from taking place in a timely manner. Such constraints could take the form of transaction costs, information gaps, government regulations, taxes, unavailability of comparable investments (in terms of risk, maturity, amount, etc.), and other impediments or imperfections in the capital markets. However, today’s large and deregulated foreign exchange markets and Eurocurrency deposit markets for the dollar and other heavily traded currencies are generally free of major impediments.

ROLE OF THE OFFSHORE DEPOSIT MARKETS FOR EURO-DOLLARS AND OTHER CURRENCIES

Forward contracts have existed in commodity markets for hundreds of years. In the foreign exchange markets, forward contracts have been traded since the nineteenth century, and the concept of interest arbitrage has been understood and described in economic literature for a long time. (Keynes wrote about it and practiced it in the 1920s.) But it was the development of the offshore Eurocurrency deposit markets—the markets for offshore deposits in dollars and other major currencies—in the 1950s and ‘60s that facilitated and refined the process of interest rate arbitrage in practice and brought it to its present high degree of efficiency, closely linking the foreign exchange market and the money markets of the major nations, and equalizing returns through the two channels. With large and liquid offshore deposit markets in operation, and with information transfers greatly improved and accelerated, it became much easier and quicker to detect any significant deviations from covered interest rate parity, and to take advantage of any such arbitrage opportunities. From the outset, deposits in these offshore markets were generally free of taxes, reserve requirements, and other government restrictions.

The offshore deposit markets in London and elsewhere quickly became very convenient for, and closely attached to, the foreign exchange market. These offshore Eurocurrency markets for the dollar and other major currencies were, from the outset, handled by the banks’ foreign exchange trading desks, and many of the same business practices were adopted. These deposits trade over the telephone like foreign exchange, with a bid/offer spread, and they have similar settlement dates and other trading conventions. Many of the same counterparties participate in both markets, and credit risks are similar.

It is thus no surprise that the interest rates in the offshore deposit market in London came to be used for interest parity and arbitrage calculations and operations. Dealers keep a very close eye on the interest rates in the London market when quoting forward rates for the major currencies in the foreign exchange market. For currencies not traded in the offshore Eurocurrency deposit markets in London and elsewhere, deposits in domestic money markets may provide a channel for arbitraging the forward exchange rate and interest rate differentials How Forward Rates are Quoted by Traders Although spot rates are quoted in absolute terms—say, x yen per dollar—forward rates, as a matter of convenience are quoted among dealers in differentials—that is, in premiums or discounts from the spot rate. The premium or discount is measured in “points,” which represent the interest rate differential between the two currencies for the period of the forward, converted into foreign exchange.

Specifically, points are the amount of foreign exchange (or basis points) that will neutralize the interest rate differential between two currencies for the applicable period. Thus, if interest rates are higher for currency A

than currency B, the points will be the number of basis points to subtract from currency A’s spot exchange rate to yield a forward exchange rate that neutralizes or offsets the interest rate differential. Most forward contracts are arranged so that, at the outset, the present value of the contract is zero. Traders in the market thus know that for any currency pair, if the base currency earns a higher interest rate than the terms currency, the base currency will trade at a forward discount, or below the spot rate; and if the base currency earns a lower interest rate than the terms currency, the base currency will trade at a forward premium, or above the spot rate.

Whichever side of the transaction the trader is on, the trader won’t gain (or lose) from both the interest rate differential and the forward premium/discount. A trader who loses on the interest rate will earn the forward premium, and vice versa. Traders have long used rules of thumb and shortcuts for calculating whether to add or subtract the points. Points are subtracted from the spot rate when the interest rate of the base currency is the higher one, since the base currency should trade at a forward discount; points are added when the interest rate of the base currency is the lower one, since the base currency should trade at a forward premium

Another rule of thumb is that the points must be added when the small number comes first in the quote of the differential, but subtracted when the larger number comes first. For example, the spot CHF might be quoted at“1.5020- 30,” and the 3-month forward at “40-60” (to be added) or “60-40” (to be subtracted). Also, the spread will always grow larger when shifting from the spot quote to the forward quote. Screens now show positive and negative signs in front of points, making the process easier still.

NON-DELIVERABLE FORWARDS (NDFS)

In recent years, markets have developed for some currencies in “non-deliverable forwards.” This instrument is in concept similar to an outright forward, except that there is no physical delivery or transfer of the local currency. Rather, the agreement calls for settlement of the net amount in dollars or other major transaction currency. NDFs can thus be arranged offshore without the need for access to the local currency markets, and they broaden hedging opportunities against exchange rate risk in some currencies otherwise considered unhedgeable. Use of NDFs with respect to certain currencies in Asia and elsewhere is growing rapidly.

OPTIONS, FORWARD CONTRACTS, SWAPS AND OTHER DERIVATIVE SECURITIES

THE SIZE OF THE MARKET

The market for derivative securities has become very large in recent years. Worldwide in the 1990's these securities provided "insurance" on an estimated $16 trillion of financial securities. In 2007, according to the International Swaps and Derivatives Association the notional value of all financial swaps was $587 trillion worldwide. The gross domestic product of the entire world in 2008 was only about $60 trillion.

The economic function of swaps and derivatives is to transfer risk from those who have it but who do not want to bear it to those who are willing to bear it for a fee. In this respect the derivatives market is much the same as the insurance industry. For example, a put option is insurance against the price of a stock falling. And, like the insurance industry, both the insuree and insurer are better off as a result of the transaction. However, one usually does not refer to this insurance function as insuring; it is called hedging.

Most of the transactions in these derivative securities is for speculation rather than for hedging. Nevertheless the speculators serve a purpose. They provide the liquidity for the market to fulfill its social function of transferring risk. For an example of the size of the market for derivatives compared to the underlying asset consider that the notional value of the credit default swaps in 2007 was $62.2 trillion. The total value of household real estate at that time was only $19.9 trillion.

A major part of the financial crisis of 2008 came as a result of businesses with risk involving their investment in home mortgages finding that that had not really transfered risk. This happened because they dealt with counter

parties who could not possibly fulfill the financial obligations they had incurred. Thus the businesses with a risk of mortgagee defaults had merely transformed that risk into counter-party risk. However because the businesses thought they had transfered the risk they more heavily invested in the risky securities. Thus when mortgage defaults began to escalate the businesses found that in fact did not really have default insurance which meant their mortgage assets were worth far less than they had thought.

The derivative market, like the insurance industry, does involve gambling. The sizes of the bets in the financial markets however are vastly greater than in the gambling industry. Salomon Brothers had in the recent past derivative contracts for more than $600 billion in securities. The leader in derivative securities has been Chemical Bank which has contracts for $2.5 trillion in securities.

The sizes of the involvement of banks and stock brokerage firms in derivative securities raises fears that there could be a catastrophic loss that would bring about a collapse of the financial system. There had been cases which demonstrate the real dangers of such speculation. A German corporation, Metallgesellschaft, had an American subsidiary, MG Corp., which had been playing the derivative market. MG reported losses in 1993 of $500 million and its total losses could go to $800 million.

On the other hand, some participants in the derivatives markets are reporting huge profits. Chemical Bank reported profits of $236 million for the first nine months of 1993 and J.P. Morgan reported gains of $512 million.

SWAPS

The derivatives market involves more than just put and calls options. There are also contracts involving swapping fixed interest rate payment streams for adjustable or floating interest rate payment streams. A company may have borrowed money under an adjustable interest rate security such as a mortgage and is now fearful that the interest rate is going to rise. It wants to protect itself against rises in the interest rates without going through the refinancing of the mortgage. The company or individual liable for an adjustable rate looks for someone who will pay the adjustable interest payments in return for receipt of fixed rate payments. This is called a swap. The origin of swaps can be identified as a deal made between IBM and the World Bank. For more on swaps and their history.

OTHER DERIVATIVE SECURITIES

There are many other contracts that businesses may find of interest. A cap is a contract that protects against rises in the interest rate beyond some limit. Likewise some businesses may want protection against a price drop beyond some level. This type of contract is called a floor. A swaption (option on a swap) gives the holder the right to enter into or the right to cancel out of a swap. Similarly there are captions and floortions (options on caps and options on floors).

FORWARD CONTRACTS AND FUTURES

Swaps, caps, and floors are recent innovations in the derivatives markets. The derivatives market traditionally included forward contracts in addition to options (puts, calls, warrants). A forward contract involved a commitment to trade a specified item at a specified price at a future date. For example, if an American company will have need of 1 million British pounds six months from now they may avoid exposure to exchange rate risk by entering into a forward contract for the pounds now. The forward contract takes whatever form the two parties agree to. There is also a market for standardized forward contracts, which is called the futures market. The standardization makes possible a wider market with greater liquidity and efficiency.

Often the futures markets eliminate the ties between specific parties, the party and the counter-party, and the risk that the other might not fulfill the contract. In the futures market everyone deals with the clearinghouse who guarantees fulfillment.

OPTIONS

In the options market there has developed some terminology that is somewhat intimidating to the uninitiated. A call option is the right to buy a share of a stock, the underlying security, at a specified price, called the exercise price or the strike price. A put option is the right to sell a share of a stock at a specified price, the exercise price or the strike price.

There is a limited time for the exercise of the call option. An American option can be exercised at any time up to and including the expiration date. A European option can only be exercised on the expiration date. The value of a call option at any time depends upon:

  • 1. The current market price of the underlying security

  • 2. The exercise price

  • 3. The interest rate

  • 4. Time remaining until expiration

  • 5. The volatility of the price of the underlying security.

When any of these change the value of the option will change. The options terminology that is most obscure is the use of Greek letters to refer to the response of the option value to changes in the variables which affect it. Δ Delta = the change in the price of the option per unit change in the price of the underlying; i.e., the increase in option value if the current market price of the stock goes up by one dollar. Delta is important in creating a perfectly hedged portfolio. The rate of change of the delta of an option is called its gamma. ρ Rho = the rate of change in the price of an option in response to a unit change in the interest rate. θ Theta = the rate of change in the price of an option with respect to time; i.e., the change as the time until expiration decreases by one unit. Vega (this is not a Greek letter) = the rate of change in the price of an option for a unit change in volatility.

FUTURES CONTRACT

In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset (e.g. oranges, oil, gold) of standardized quantity and quality at a specified future date at a price agreed today (the futures price). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all – that is, for financial futures, the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange. A closely related contract is a forward contract; they differ in certain respects. Futures contracts are very similar to forward contracts, except they are exchange-traded and defined on standardized assets.

Unlike forwards, futures typically have interim partial settlements or "true-ups" in margin requirements. For typical forwards, the net gain or loss accrued over the life of the contract is realized on the delivery date. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations. Futures contracts, or simply futures, (but not future or future contracts) are exchange-traded derivatives. The exchange's clearing house acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.

ORIGIN

Aristotle described the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a poor yield. When the harvest time came, and many presses were wanted concurrently and suddenly, he let them out at any rate he pleased, and made a large quantity of money.

The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, to meet the needs of samurai who—being paid in rice, and after a series of bad harvests—needed a stable conversion to coin. The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864, which were called futures contracts. This contract was based on grain trading and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world. By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.

STANDARDIZATION

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term

interest rate. The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a

fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted.

The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the

case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point -- the location where delivery must be made. The delivery month.

The last trading date.

Other details such as the commodity tick, the minimum permissible price fluctuation.

MARGIN

MARGIN To minimize <a href=credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract's value. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin. Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. " id="pdf-obj-6-4" src="pdf-obj-6-4.jpg">

To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract's value. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin.

Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day.

Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client’s account. Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term “initial margin” and “variation margin”.

The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets). A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.

Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls.

Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1) (year/trade duration) -1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

Settlement - physical versus cash-settled futures

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller

of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. [8] Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item - i.e. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.

Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading, as well as the final settlement price for that contract. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading months. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge.

At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.

PRICING

When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. This is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist - for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date) - the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.

ARBITRAGE ARGUMENTS

Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply, or may be freely created. Here, the forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away.

Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r. or, with continuous compounding This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.

Pricing via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today's supply and demand for the underlying asset in the futures. In a deep and liquid market, supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship. By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as cornering the market), the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.

RELATIONSHIP BETWEEN ARBITRAGE ARGUMENTS AND EXPECTATION

The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk- neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.

CONTANGO AND BACKWARDATION

The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation.

FUTURES CONTRACTS AND EXCHANGES

CONTRACTS

There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes. For information on futures markets in specific underlying commodity markets, follow the links. For a list of tradable commodities futures contracts, see List of traded commodities. See also the futures exchange article.

Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.

Exchanges

Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 90 futures and futures options exchanges worldwide trading to include: [9]

CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives (including US

Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (Dow Jones Industrial Average); Metals (Gold, Silver), Index (NASDAQ, S&P, etc.) Intercontinental Exchange (ICE Futures Europe) - formerly the International Petroleum Exchange trades energy including crude oil, heating oil, natural gas and unleaded gas

NYSE Euronext - which absorbed Euronext into which London International Financial Futures and Options Exchange or LIFFE (pronounced 'LIFE') was merged. (LIFFE had taken over London

Commodities Exchange ("LCE") in 1996)- softs: grains and meats. Inactive market in Baltic Exchange shipping. Index futures include EURIBOR, FTSE 100, CAC 40, AEX index. South African Futures Exchange - SAFEX

Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures)

Tokyo Financial Exchange - TFX - (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate

Futures) Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures)

Intercontinental Exchange (ICE Futures U.S.) - formerly New York Board of Trade - softs: cocoa, coffee, cotton, orange juice, sugar

ROFEX - Rosario (Argentina) Futures Exchange

Codes

Most Futures contracts codes are four characters. The first two characters identify the contract type, the third character identifies the month and the last character is the last digit of the year. Third (month) futures contract codes are

January = F

February = G

March = H

April = J

May = K

June = M

July = N

August = Q

September = U

October = V

November = X

December = Z

Example: CLX0 is a Crude Oil (CL), November (X) 2010 (0) contract.

WHO TRADES FUTURES?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper", while they have no practical use for or intent to actually take or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract. Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate.

For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.xAn example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index.

The Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased), the portfolio manager can close the contract and make purchases of each individual stock. The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.

OPTIONS ON FUTURES

In many cases, options are traded on futures, sometimes called simply "futures options". A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. See the Black-Scholes model, which is the most popular method for pricing these option contracts. Futures are often used since they are delta one instruments.

FUTURES CONTRACT REGULATIONS

All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the United States government. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rules. Although by law the commission regulates all transactions, each exchange can have its own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out.

The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as the 'Commitments of Traders Report', COT-Report or simply COTR.

DEFINITION OF FUTURES CONTRACT

Following Björk we give a definition of a futures contract. We describe a futures contract with delivery of item J at the time T:

There exists in the market a quoted price F(t,T), which is known as the futures price at time t for delivery of J at time T.

At time T, the holder pays F(T,T) and is entitled to receive J.

During any time interval (s,t], the holder receives the amount F(t,T) − F(s,T).

The spot price of obtaining the futures contract is equal to zero, for all time t such that t < T.

NONCONVERGENCE

Some exchanges tolerate 'Nonconvergence', the failure of futures contracts and the value of the physical commodities they represent to reach the same value on 'contract settlement' day at the designated delivery points. An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures.

SRW futures have settled more than 20¢ apart on settlement day and as much as $1.00 difference between settlement days. Only a few participants holding CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of commodities to settle futures contracts. Therefore, it's impossible for almost any individual producer to 'hedge' efficiently when relying on the final settlement of a futures contract for SRW. The trend is for the CBOT to continue to restrict those entities that can actually participate in settling commodities contracts to those that can ship or receive large quantities of railroad cars and multiple barges at a few selected sites. The Commodity Futures Trading Commission, which has oversight of the futures market in the United States, has made no comment as to why this trend is allowed to continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the underlying commodity they represent is the basis of integrity for a futures market. It follows that the function of 'price discovery', the ability of the markets to discern the appropriate value of a commodity reflecting current conditions, is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with the commodities they represent.

FUTURES VERSUS FORWARDS

While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in two main respects:

Futures are exchange-traded, while forwards are traded over-the-counter.

Thus futures are standardized and face an exchange, while forwards are customized and face a non- exchange counterparty.

Futures are margined, while forwards are not.

Thus futures have significantly less credit risk, and have different funding.

EXCHANGE VERSUS OTC

Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties.

THUS:

Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-

the-counter. In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.

MARGINING

Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). Forwards do not have a standard. They may transact only on the settlement date. More typical would be for the parties to agree to true up, for example, every quarter. The fact that forwards are not margined daily means that, due to movements in the price of the underlying asset, a large differential can build up between the forward's delivery price and the settlement price, and in any event, an unrealized gain (loss) can build up.

Again, this differs from futures which get 'trued-up' typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. This true- up occurs by the "loss" party providing additional collateral; so if the buyer of the contract incurs a drop in value, the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account. In a forward though, the spread in exchange rates is not trued up regularly but, rather, it builds up as unrealized gain (loss) depending on which side of the trade being discussed.

This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs, the time the contract is closed prior to expiration) - assuming the parties must transact at the underlying currency's spot price to facilitate receipt/delivery. The result is that forwards have higher credit risk than futures, and that funding is charged differently. In most cases involving institutional investors, the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring back and forth small sums of cash. The threshold amount for daily futures variation margin for institutional investors is often $1,000.

The situation for forwards, however, where no daily true-up takes place in turn creates credit risk for forwards, but not so much for futures. Simply put, the risk of a forward contract is that the supplier will be unable to deliver the referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss, not the gain or loss over the life of the contract. In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, further limiting credit risk in futures.

Example: Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This means that the "mark-to-market" calculation would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of the other side of the future. That is, the loss party wires cash to the other party.

A forward-holder, however, may pay nothing until settlement on the final day, potentially building up a large balance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny effects of convexity bias (due to earning or paying interest on margin), futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes, while the forward's spot price converges to the settlement price. Thus, while under mark to market accounting, for both assets the gain or loss accrues over the holding period; for a futures this gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized until expiry. Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, but also on the path of prices on the way. This difference is generally quite small though. With an exchange-traded future, the clearing house interposes itself on every trade. Thus there is no risk of counterparty default. The only risk is that the clearing house defaults (e.g. become bankrupt), which is considered very unlikely.

DIFFERENCES

BETWEEN

A

FUTURES

CONTRACT

AND

A

FORWARD

CONTRACT

Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions.

Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never. Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract.

Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date. Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place.

FORECASTING FOREIGN EXCHANGE RATES

INTRODUCTION

Foreign exchange rate forecasting has become increasingly important since the dissolution of the Bretton Woods system and the advent of floating exchange rates in 1973. The substantial increase in exchange rate volatility has concomitantly placed a priority on the managerial function of foreign exchange risk management.

Exchange rate forecasts are used by multinational corporations in many important areas of financial management. For example, managers use foreign exchange forecasts to convert future foreign cash flows into domestic currency units; foreign and domestic costs of capital (or returns on investment) can then be compared when making a foreign financing or investment decision. Likewise, forecasts are required for deciding whether or not a foreign currency exposure should be hedged or to what extent the exposure needs to be hedged. Monthly projections of foreign subsidiaries' expenses and revenues, which are included in annual budgets, also require foreign exchange rate forecasts. Furthermore, when formulating long-range strategic plans such as a subsidiary's asset and liability structure, pricing policy, or product mix, foreign exchange rate forecasts are again needed.

CURRENTLY USED FOREIGN EXCHANGE FORECASTING METHODS

The foreign exchange rate forecasting methods in use today by both commercial services and corporate forecasting departments are primarily econometric, judgmental, or technical methods, as summarized by Levich (1983). The forward rate, which is considered an unbiased predictor of the future spot rate by some scholars (Kohlhagen 1979 and Levich 1979), may also be used to forecast foreign exchange rates in lieu of either purchasing a commercial forecast or incurring the expense of forecasting in-house. The forward rate is the rate of exchange at which any may contract to buy or sell a foreign currency at a designated future date. As such, forward rates can be used as forecasts of future spot exchange rates. Forward contracts may be of different maturities; the more common ones are one-month, three-month, six-month, and one-year contracts.

Econometric methods usually employ a single multiple regression equation. The independent variables are economic in nature while the dependent variable is the foreign exchange rate to be forecasted. The specification of independent variables may be prompted by various economic theories such as purchasing power parity, monetary theory, portfolio balance theory, or the asset approach (Levich 1982). Single-equation models are often an oversimplification of the real world and, for this reason, some econometric models are comprised of systems of equations.

PURCHASING POWER PARITY

Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative price levels of two countries. The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in 1918. The concept is founded on the law of one price; the idea that in absence of transaction costs, identical goods will have the same price in different markets. In its "absolute" version, the purchasing power of different currencies is equalized for a given basket of goods. In the "relative" version, the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate.

Deviations from the theory imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP adjusted" and converted into common units. The best-known and most-used purchasing power adjustment is the Geary–Khamis dollar (the "international dollar").Real exchange rate fluctuations are mostly due to different rates of inflation between the two economies. Aside from this volatility, consistent deviations of the market and purchasing power adjusted exchange rates can be observed, for example (market exchange rate) prices of non-traded goods and services are usually lower in countries with lower incomes (a U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States).

There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,100 while on a PPP basis it is about US$3,000. This means that if calculated at nominal exchange rates, India has the eleventh largest economy, while at PPP-adjusted rates; it has the fourth largest economy in the world. At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is only US$37,304.

PPP MEASUREMENT

The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries. Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.

BIG MAC INDEX

An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index popularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc.

However, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staples—i.e. the Big Mac is not a mainstream 'cheap' meal as it is in the west but a luxury import for the middle classes and foreigners.

NEED FOR PPP ADJUSTMENTS TO GDP

The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign- exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries.

For example, if the value of the Mexican peso falls by half compared to the U.S. dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.

PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.

DIFFICULTIES

The main reasons why different measures do not perfectly reflect standards of living are

PPP numbers can vary with the specific basket of goods used, making it a rough estimate.

Differences in quality of goods are hard to measure and thereby reflect in PPP.

PPP calculations are often used to measure poverty rates.

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:

  • 1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically.

  • 2. Tradable goods such as non-perishable commodities that can be sold on the international market (e.g. diamonds).

The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchange rate. (For more details of why, see: Penn effect). More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rate, it won't buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced crops. The relative price differential between tradable and non-tradable from high-income to low-income countries is a consequence of the Balassa- Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like Ethiopia), as against high income countries (like Switzerland).

The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a cheaper factor of production than is available to factories in richer countries. PPP calculations tend to overemphasize the primary sectoral contribution, and under emphasize the industrial and service sectoral contributions to the economy of a nation.

ADDITIONAL ISSUES

In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries. The International Comparison Program, which PPP estimates are based off, require the disaggregation of national accounts into production, expenditure or (in some cases) income, and not all participating countries routinely disaggregate their data into such categories. Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for comparison between the Ethiopian laborer who lives on teff with the Thai laborer who lives on rice, because teff is impossible to find in Thailand and vice versa, so the price of rice in Ethiopia or teff in Thailand cannot be determined. As a general rule, the more similar the price structure between countries, the more valid the PPP comparison.

PPP levels will also vary based on the formula used to calculate price matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages. Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which is not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries.

2005 ICP

The 2005 ICP round resulted in large downward adjustments of PPP (or upward adjustments of price level) for several Asian countries, including China (-40%), India (-36%), Bangladesh (-42%) and the Philippines (-43%). Surjit Bhalla has argued that these adjustments are unrealistic. For example, in the case of China, backward extrapolation of 2005 ICP PPP based on Chinese annual growth rates would yield a 1952 PPP per capita of $153 1985 International dollars, but Pritchett has persuasively argued that $250 1985 dollars is the minimum required to sustain a population, or has ever been observed for more than a short period. Therefore, both the 2005 ICP PPP for China and China's growth rates cannot both be correct. Angus Maddison has calculated somewhat slower growth rates for China than official figures, but even under his calculations, the 1952 PPP per capita comes to only $229.

Deaton Heston has suggested that the discrepancy can be explained by the fact that the 2005 ICP examined only urban prices, which overstate the national price level for Asian countries, and also the fact that Asian countries adjusted for productivity across noncomparable goods such as government services, whereas non-Asian countries did not make such an adjustment. Each of these two factors, according to him, would lead to an underestimation of GDP by PPP of about 12%.

INTEREST RATE PARITY

Interest rate parity, or sometimes incorrectly known as International Fisher effect, is an economic concept, expressed as a basic algebraic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economic models. There is evidence to support as well as to refute the concept. Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.

Looked at differently, interest rate parity says that the spot price and the forward, or futures price, of a currency incorporate any interest rate differentials between the two currencies assuming there are no transaction costs or taxes. Two versions of the identity are commonly presented in academic literature: covered interest rate parity and uncovered interest rate parity.

COVERED INTEREST RATE PARITY

An example

This would imply that one dollar invested in the US < one dollar converted into a foreign currency and invested abroad. Such an imbalance would give rise to an arbitrage opportunity, where in one could borrow at the lower effective interest rate in US, convert to the foreign currency and invest abroad. The following rudimentary example demonstrates covered interest rate arbitrage (CIA). Consider the interest rate parity (IRP) equation,

Assume:

the 12-month interest rate in US is 5%, per annum

the 12-month interest rate in UK is 8%, per annum

the current spot exchange rate is 1.5 $/£

the forward exchange rate implied by a forward contract maturing 12 months in the future is 1.5 $/£.

Clearly, the UK has a higher interest rate than the US. Thus the basic idea of covered interest arbitrage is to borrow in the country with lower interest rate and invest in the country with higher interest rate. All else being equal this would help you make money riskless. Thus,

Per the LHS of the interest rate parity equation above, a dollar invested in the US at the end of the

12-month period will be,

$1 · (1 + 5%) = $1.05

Per the RHS of the interest rate parity equation above, a dollar invested in the UK (after

conversion into £ and back into $ at the end of 12-months) at the end of the 12-month period will be,

$1 · (1.5/1.5)(1 + 8%) = $1.08

Thus one could carry out a covered interest rate (CIA) arbitrage as follows,

  • 1. Borrow $1 from the US bank at 5% interest rate.

  • 2. Convert $ into £ at current spot rate of 1.5$/£ giving 0.67£

4.

Purchase a forward contract on the 1.5$/£ (i.e. cover your position against exchange rate fluctuations)

At the end of 12-months

  • 1. 0.67£ becomes 0.67£(1 + 8%) = 0.72£

  • 2. Convert the 0.72£ back to $ at 1.5$/£, giving $1.08

  • 3. Pay off the initially borrowed amount of $1 to the US bank with 5% interest, i.e $1.05

The resulting arbitrage profit is $1.08 − $1.05 = $0.03 or 3 cents per dollar.

Obviously, arbitrage opportunities of this magnitude would vanish very quickly.

In the above example, some combination of the following would occur to reestablish Covered Interest Parity and extinguish the arbitrage opportunity:

US interest rates will go up

Forward exchange rates will go down

Spot exchange rates will go up

UK interest rates will go down

UNCOVERED INTEREST RATE PARITY

The uncovered interest rate parity postulates that

The equality assumes that the risk premium is zero, which is the case if investors are risk-neutral. If investors

are not risk-neutral then the forward rate (F + 1 ) can differ from the expected future spot rate (E[S + 1 ]), and covered and uncovered interest rate parities cannot both hold.

The uncovered parity is not directly testable in the absence of market expectations of future exchange rates. Moreover, the above rather simple demonstration assumes no transaction cost, equal default risk over foreign and domestic currency denominated assets, perfect capital flow and no simultaneity induced by monetary authorities. Note also that it is possible to construct the UIP condition in real terms, which is more plausible.

UNCOVERED INTEREST PARITY EXAMPLE

An example for the uncovered interest parity condition: Consider an initial situation, where interest rates in the home country (e.g. U.S.) and a foreign country (e.g. Japan) are equal. Except for exchange rate risk, investing in the US or Japan would yield the same return. If the dollar depreciates against the yen, an investment in Japan would become more profitable than a US-investment - in other words, for the same amount of yen, more dollars can be purchased. By investing in Japan and converting back to the dollar at the favorable exchange rate, the return from the investment in Japan, in the dollar terms, is higher than the return from the direct investment in the US. In order to persuade an investor to invest in the US nonetheless, the dollar interest rate would have to be higher than the yen interest rate by an amount equal to the devaluation (a 20% depreciation of the dollar implies a 20% rise in the dollar interest rate).

Technically however, a 20% depreciation in the dollar only results in an approximate rise of 20% in U.S. interest rates. The exact form is as follows: Change in spot rate (Yen/Dollar) equals the dollar interest rate minus the yen interest rate, with this expression being divided by one plus the yen interest rate.

UNCOVERED VS. COVERED INTEREST PARITY EXAMPLE

Let's assume you wanted to pay for something in Yen in a month's time. There are several ways to do this.

(a) Buy Yen forward 30 days to lock in the exchange rate. Then you may invest in dollars for 30 days until you must convert dollars to Yen in a month. This is called covering because you now have covered yourself and have no exchange rate risk.

(b) Convert spot to Yen today. Invest in a Japanese bond (in Yen) for 30 days (or otherwise loan out Yen for 30 days) then pay your Yen obligation. Under this model, you are sure of the interest you will earn, so you may convert fewer dollars to Yen today, since the Yen will grow via interest. Notice how you have still covered your exchange risk, because you have simply converted to Yen immediately.

(c) You could also invest the money in dollars and change it for Yen in a month.

According to the interest rate parity, you should get the same number of Yen in all methods. Methods (a) and (b) are covered while (c) is uncovered.

In method (a) the higher (lower) interest rate in the US is offset by the forward discount (premium).

In method (b) The higher (lower) interest rate in Japan is offset by the loss (gain) from converting spot instead of

using a forward. Method (c) is uncovered, however, according to interest rate parity, the spot exchange rate in 30 days should become the same as the 30 day forward rate. Obviously there is exchange risk because you must see if this actually happens.

General Rules: If the forward rate is lower than what the interest rate parity indicates, the appropriate strategy would be: borrow Yen, convert to dollars at the spot rate, and lend dollars.

If the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be: borrow dollars, convert to Yen at the spot rate, and lend the Yen.

COST OF CARRY MODEL

A slightly more general model, used to find the forward price of any commodity, is called the cost of carry model. Using continuously compounded interest rates, the model is: where F is the forward price, S is the spot price, e is the base of the natural logarithms, r is the risk free interest rate, s is the storage cost, c is the convenience yield, and t is the time to delivery of the forward contract (expressed as a fraction of 1 year).For currencies there is no storage cost, and c is interpreted as the foreign interest rate. The currency prices should be quoted as domestic units per foreign units.

If the currencies are freely tradeable and there are minimal transaction costs, then a profitable arbitrage is possible if the equation doesn't hold. If the forward price is too high, the arbitrageur sells the forward currency, buys the spot currency and lends it for time period t, and then uses the loan proceeds to deliver on the forward contract. To complete the arbitrage, the home currency is borrowed in the amount needed to buy the spot foreign currency, and paid off with the home currency proceeds of forward contract. Similarly, if the forward price is too low, the arbitrageur buys the forward currency, borrows the foreign currency for time period t and sells the foreign currency spot. The proceeds of the forward contract are used to pay off the loan. To complete the arbitrage, the home currency from the spot transaction is lent and the proceeds used to pay for the forward contract.

INTERNATIONAL FISHER EFFECT

The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the nominal exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing. This is also known as the assumption of Uncovered Interest Parity.

MOTIVATION

The Fisher hypothesis says that the real interest rate in an economy is independent of monetary variables. If we add to this the assumption that real interest rates are equated across countries, then the country with the lower nominal interest rate would also have a lower rate of inflation and hence the real value of its currency would be risen over time.

CAPITAL MARKET INTEGRATION

The generalized Fisher effect holds that real interest rates must be the same across borders. However, validity of the generalized Fisher effect requires capital market integration. In order for the generalized Fisher theorem to hold, capital markets must be integrated. That is, capital must be allowed to flow freely across borders. In general, the capital markets of developed countries are integrated. However, in many less developed countries, we can observe currency restrictions and other regulation that inhibit integration.

EXAMPLE

Suppose that the current spot exchange rate for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5 percent in the U.S. and 7 percent in Britain, what is the expected spot exchange per pound rate 12 months from now according to the International Fisher Effect? The International Fisher Effect estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 = $1.4071.