NWR: Euro at $1.26 vs dollar today.

Indeed, Tom, futures and forwards are different, but only in structure. They share the same pricing principle, which is spot price plus carrying costs for the duration of the contract.

Jonathan, the fundamental point I was trying to make is that it's irrelevant, from an economic standpoint, whether a Euro forward/future is higher or lower than the spot rate. The fact that it's higher should not be a disincentive to hedge, and the fact that it's lower should not be an attraction. If that's clear, I'm happy.

If it's not clear, then Joe's point about an example would be in order, but that would have to be tomorrow. I'm tired, dinner is served, and there's wine to be drunk.
 
Speaking as a former finance professor, futures and forwards are different contracts but not in ways that in most cases are relevant to pricing. Selling at a forward rate locks in the price for a given quantity of foreign currency in the future; using the spot market means that the future price is uncertain. If the person in question is fairly certain about needing to purchase currency it is not obvious that the forward transaction is any more speculative than the spot transaction.

And pace SF Joe, when I took International Finance all those years ago we discussed speculation, hedging and arbitrage (clearly distinguishable in their stylized versions) and how all three affected markets. (Speculators bought and sold currencies based on their expectation of future prices, hedgers bought and sold to reduce the uncertainty about future costs or revenues and arbitrageurs looked for deviations in the relation between futures and spot rates given the interest rates in the two currencies)
 
I'm now somewhat lost. Cole makes a forward contract sound like a futures contract, with price controlled entirely by people's guesses about the worth of a currency at a future date. I'm not sure what a worksheet would prove to me except the theory that people's guesses will always come to be more or less selling the current cost plus interest and buying the future cost plus interest, a very much weaker claim than Oswaldo was making.

Whether that is the case or not, assuming one has a bank account in which to put Euros one buys today, whether a forward is higher or lower makes every difference in the world in the decision about whether to buy now or later. Of course, if what one wants to do is predict price without regard to its being higher or lower, then one will hedge by buying forwards regardless of relative price.
 
originally posted by Jonathan Loesberg:
I'm now somewhat lost. Cole makes a forward contract sound like a futures contract, with price controlled entirely by people's guesses about the worth of a currency at a future date. I'm not sure what a worksheet would prove to me except the theory that people's guesses will always come to be more or less selling the current cost plus interest and buying the future cost plus interest, a very much weaker claim than Oswaldo was making.

Whether that is the case or not, assuming one has a bank account in which to put Euros one buys today, whether a forward is higher or lower makes every difference in the world in the decision about whether to buy now or later. Of course, if what one wants to do is predict price without regard to its being higher or lower, then one will hedge by buying forwards regardless of relative price.
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Leave it to profs. to try and complicate things. A hedge is just an exact and opposite futures position to a cash position. For commodities that eliminates all price risk-except for the basis. In the profs case-it appears he is short euros-ie having to make an euro house payment each yr. By doing nothing the prof is speculating each day on the price level of the euro. By buying the equivalent euro futures-to offset the short cash position- he locks in the price level for the euros to make the house payment and all speculation on the price level of the euros ceases.

In talking to some wine importers in the US and Oz-it seems most do not trade currency to lock in rates. The reason most frequently given is-what if I lock in a bad rate-it then gives my competitor a price advantage. Of course, options could be used to protect against this happening-but not one has mentioned them. It seems me that as we enter the end game of sovereign debt that currency risk is going to be much higher than most anticipate with overnight devaluations a liklihood.

mark meyer
 
originally posted by mark meyer:
originally posted by Jonathan Loesberg:
I'm now somewhat lost. Cole makes a forward contract sound like a futures contract, with price controlled entirely by people's guesses about the worth of a currency at a future date. I'm not sure what a worksheet would prove to me except the theory that people's guesses will always come to be more or less selling the current cost plus interest and buying the future cost plus interest, a very much weaker claim than Oswaldo was making.

Whether that is the case or not, assuming one has a bank account in which to put Euros one buys today, whether a forward is higher or lower makes every difference in the world in the decision about whether to buy now or later. Of course, if what one wants to do is predict price without regard to its being higher or lower, then one will hedge by buying forwards regardless of relative price.
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Leave it to profs. to try and complicate things. A hedge is just an exact and opposite futures position to a cash position. For commodities that eliminates all price risk-except for the basis. In the profs case-it appears he is short euros-ie having to make an euro house payment each yr. By doing nothing the prof is speculating each day on the price level of the euro. By buying the equivalent euro futures-to offset the short cash position- he locks in the price level for the euros to make the house payment and all speculation on the price level of the euros ceases.

In talking to some wine importers in the US and Oz-it seems most do not trade currency to lock in rates. The reason most frequently given is-what if I lock in a bad rate-it then gives my competitor a price advantage. Of course, options could be used to protect against this happening-but not one has mentioned them. It seems me that as we enter the end game of sovereign debt that currency risk is going to be much higher than most anticipate with overnight devaluations a liklihood.

mark meyer
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Options cost more and option prices increase with increases in volatility. Cost is why few people would hedge with options.
 
Actually, my decision is simple. I can either buy now and put the Euros in a bank, speculate and buy later when I will need them (or maybe speculation is buying now) or, if forwards are lower than current rates, speculate and buy them. The complications occur when finance types try to explain to me what I am doing. But that's always the way with theory and it is at least interesting to know how what you are doing works. This discussion has not yet quite done that for me.
 
originally posted by Jonathan Loesberg:
whether a forward is higher or lower makes every difference in the world in the decision about whether to buy now or later.
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You still don't get it, and insist on not getting it. It makes no difference whatsoever. Let go of your certainty for a moment and you will learn something.

Whenever you buy a currency forward, you simultaneously sell your own short. You start to earn the interest rate of the currency you've bought and pay the interest rate of the currency you've sold.

If EUR and USD interest rates happen to be the same, what you pay is what you earn, so there's no difference between the spot and forward rates because there's no need to compensate for discrepancies in interest rates.

But if, as is usually the case, the Euro and the Dollar have different interest rates, there has to be a positive or negative difference between the spot and forward rates to compensate for the asymmetry that one party is long (receiving) a higher interest rate and short (paying) a lower interest rate. One is a net receiver of interest rates and the other is a net payer of interest rates. The paying party is not an idiot, so he will only enter the transaction if the difference between spot and forward is such as to equalize the situation between them.

In other words, whatever you "lose" by buying a forward priced higher than spot, you "earn" by being long a currency with a higher interest rate and short a currency with a lower interest rate (you are a net earner). Whatever you "earn" by buying a forward priced lower than spot, you "lose" by being long a currency with a lower interest rate and short a currency with a higher interest rate (you are a net receiver).

The difference between forwards and futures is only obscuring this discussion. One is custom made and the other is cookie-cutter. From the financial math point of view, they are identical.

Think of it this way: if you are discouraged from buying EUR forwards because they are priced higher than spot, Europeans would conversely be encouraged to buy USD forwards because they would be priced lower than spot. This doesn't happen because what one hand gives, the other takes away.
 
originally posted by Jonathan Loesberg:
I'm now somewhat lost. Cole makes a forward contract sound like a futures contract, with price controlled entirely by people's guesses about the worth of a currency at a future date. I'm not sure what a worksheet would prove to me except the theory that people's guesses will always come to be more or less selling the current cost plus interest and buying the future cost plus interest, a very much weaker claim than Oswaldo was making.

Whether that is the case or not, assuming one has a bank account in which to put Euros one buys today, whether a forward is higher or lower makes every difference in the world in the decision about whether to buy now or later. Of course, if what one wants to do is predict price without regard to its being higher or lower, then one will hedge by buying forwards regardless of relative price.
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To take your points one at a time;

Forwards and futures differ in ways that are not relevant to pricing. At any time the forward price and the corresponding future price are almost exactly the same. If there is a nontrivial difference, there is a guy who buys the cheap one and sells the expensive one, reducing the difference.

Both are priced to reflect differences in interest rates. To take a simple case, consider the Euro and Dollar for a one year ahead period. Assume the current price is $1.00/Euro and the US interest rate is 100% and the European rate is zero (an extreme example to make a point). If you have 100 Dollars today you can either convert to Euros today or put them in the bank and end up with 200 Dollars in a year (100% interest rate). Or you can buy 100 Euros (current exchange rate is $1/Euro) today and deposit them in a bank and end up with 100 Euros in one year (zero interest rate).

The one year forward rate will be $2.00. If it is not, then arbitrageurs will have a profit opportunity. For example, if the forward price were $1, you could borrow 100 Euros and buy 100 Dollars; investing the Dollars you would have 200 in a year which you could sell forward and pay off your Euro debt and have 100 left over to spend on wine.

Does the forward price tell you whether you should buy Euros today at $1 or in a year at $2? Not really. But this post is already too long. If you accept this logic we can go on to the next question.
 
Cole has explained better than Oswaldo what the situation is. They are both empirically wrong about my choices, since I am not in fact trading Euros now for Euros then but buying either Euros or forwards now. My interest rate situation is not a market rate interest situation. Bank rates for individuals over the course of one to three months is virtually zero (the situation might be different if I were selling bonds in dollars for bonds in Euros, but in fact I am not). So, Oswaldo and Cole to the contrary notwithstanding, the cost of the forward vs. the cost of the Euro today are to me directly comparable without regard to interest rates--regardless of what they are to international markets. In calculating what individuals should do, you have to calculate what their actual costs are, not what their theoretical market costs are. So, Oswaldo, I'll use your own condescending tone to you: listen to my situation and learn something about why individuals do not always operate according to market laws.

No one has yet answered whether the calculation of interest rate differentials in Euro today and Euro three months from now is de jure or based on estimations of what interest rates will be. I'm assuming it's not de jure and everybody thinks that distinction is irrelevant. In a futures situation, when I make an offer to pay a price for a given stock say 3 months from now, I am betting that three months from now the stock will be worth more than that price and the other person in the deal is making the opposite bet. If we didn't have these different views, we would have no reason to make this contract. Are you all really trying to tell me that this motive does not enter into forward contracts? If it does not, what is the motive for such contractual arrangements. If they all come out equal, why bother with them.
 
originally posted by Jonathan Loesberg:
If we didn't have these different views, we would have no reason to make this contract. Are you all really trying to tell me that this motive does not enter into forward contracts? If it does not, what is the motive for such contractual arrangements. If they all come out equal, why bother with them.
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One side is willing to accept the risk of price fluctuation, the other is not.
 
originally posted by Tom Glasgow:
originally posted by Jonathan Loesberg:
If we didn't have these different views, we would have no reason to make this contract. Are you all really trying to tell me that this motive does not enter into forward contracts? If it does not, what is the motive for such contractual arrangements. If they all come out equal, why bother with them.
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One side is willing to accept the risk of price fluctuation, the other is not.
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But this is precisely what Oswaldo insists does not enter into the equation. Do you not think you are disagreeing with him? If not, why not? If it does enter into the equation, how is this not a usual futures speculation?
 
originally posted by Jonathan Loesberg:


No one has yet answered whether the calculation of interest rate differentials in Euro today and Euro three months from now is de jure or based on estimations of what interest rates will be. I'm assuming it's not de jure and everybody thinks that distinction is irrelevant. In a futures situation, when I make an offer to pay a price for a given stock say 3 months from now, I am betting that three months from now the stock will be worth more than that price and the other person in the deal is making the opposite bet. If we didn't have these different views, we would have no reason to make this contract. Are you all really trying to tell me that this motive does not enter into forward contracts? If it does not, what is the motive for such contractual arrangements. If they all come out equal, why bother with them.
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It's today's interest rates; so if the Euro and US interest rates are both zero, then the Forward/Futures price will be equal to the current spot price.

As to motivations to trade, there are (as I originally suggested) three:

Hedgers: they will pay or receive FX in the future and want to lock in a local currency price. They reduce the uncertainty in terms of their local currency values but create uncertainty in that their unhedged competitors might have a lower price and reduce their sales.

Arbitrageurs: they look at bank deposit rates and lock in profits as I noted above when there is a discrepancy between relevant spot/forward rates given today's interest rates.

Speculators: they look at the future/forward price relative to their own estimate of the future spot rate and bet on the difference.

E.g., with zero interest rates today in both the US and Europe then the relevant futures/forward rates will be equal to the spot rate. Hedgers in both places will hedge what they want to hedge, buying/selling futures and forwards depending on the amount they want to hedge. Speculators will be on the future movement of the Euro/Dollar. Arbitrageurs will take advantage of any discrepancy between futures/forward and spot prices and take out loans/make deposits to bring the Forward Spot relation back to what it ought to be. It is not "de jure" but "de facto" as arbs would leave money on the table if it were not so.

Better?
 
originally posted by Ian Fitzsimmons:
originally posted by SFJoe:
Ian,

I've never heard the cognoscenti talk about speculation, but it could be I go to the wrong bars.
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Over my head by at least a foot.
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It's not a term I hear used unselfconsciously by people ITB. But I am off in my own little world.
 
Cole,

This is much better. I have a couple of questions:

1)Is it the fact that there is no difference between forward rates and spot rates now? The Times doesn't report forward rates as they used to and I don't want to bother my financial agent on a wine board discussion.

2)The current bank exchange rate for the Euro is $1.24. According to what you are describing, my choices right now are to buy at $1.24 or to buy a forward at whatever, which will represent a difference only in the differential interest rates. If I owned Euros and I thought they were going to fall to say parity with the dollar in three months, and I could find someone who thought they were only going to fall another nickel, why would I not offer to sell Euros at $1.18 and why would he not want to buy them and why is there not a market in which such trading takes place?
 
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