NWR: Euro at $1.26 vs dollar today.

[SFJoe]

I'm not really a currency guy, but I think I'm still missing Jonathan's point, and I may let that continue. Too many paying clients waiting on my pearls of wisdom. Interest rates fluctuate frequently, Jonathan, without any government action. Inflation expectations, anticipated currency revaluations, creditworthiness of government or private borrowers, and etc. The arbs and their computers ensure that these changes are instantly reflected in the currency contracts.

I think one missing piece might be that Oswaldo views these forward contracts as symmetric. There is a mirror image on each side of the transaction. You always see them from your perspective in dollars buying euros, but someone else is selling euros to you and receiving dollars in exchange later. The various parties' supply and demand for future currency for every reason under the sun--wine, vacation homes, pure trading--are balanced in the price, and what's left is the carrying cost, almost entirely the difference in interest rates for dealers who are active in the market and trade in volume. The markup to a retail buyer is higher, but still not directional--it's about the same for the guy in Avignon who chooses to spend his summers in Washington. (OK, maybe that guy is nuts and you can charge him more).

 

[SFJoe]

originally posted by Jonathan Loesberg:
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?

The current exchange rate contains the result of that argument. Offers to sell at non-market prices are either too high (cheaper in the market, so no trade) or too low (instantly hit by some trading computer and the profit pocketed in milliseconds), money just given away.

If everyone agreed that the euro was going to fall over the coming months it would already have done so.

The difference between forward and spot rates will be low because short term interest rates in both dollars and euros are low.

I'm going back to my day job now.

 

[Oswaldo Costa]

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.

There is a USD yield curve and a EUR yield curve that varies daily. The premium/discount for, say, a 90 day forward will be based on a comparison of the 90 day rates for each currency.

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.

That is correct, this motive does not enter into forward agreements. This motive affects only spot rates. Forward rates are unaffected by supply and demand for the commodity, or bets on its price evolution.

The motive for such contractual arrangements is that by making delivery a future event, you can make a financial bet without the messiness of taking delivery. You can liquidate the transaction before delivery happens.

originally posted by Jonathan Loesberg:
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?

If you need to buy EUR to make a payment in Europe in 90 days, you can buy it spot today for 1.24 (representing a bet that the Dollar will weaken) and invest it for three months and earn, say, one cent of interest or you can buy a 90 day forward for 1.25 (also representing a bet that the Dollar will weaken). These are equivalent transactions. If you thought the EUR was going to fall to parity, you would sell a 90 EUR forward at 1.25 (minus bid/ask spread) and then buy it back after 89 days at whatever the price is then (spot + one day interest).

Forward contracts are designed for institutions because counterparty risk is assessed by corporate credit departments and doesn't usually require the posting of collateral. But you, as an individual, can buy and sell EUR futures easily and cheaply by opening a futures brokerage account and posting 10% margin. If you have a position with respect to the currency and want to make a bet on it, don't be deterred by whether the future price is higher or lower than spot, because that has no bearing on your ability to do so, or the cost of doing so.

 

[Cole Kendall]

WARNING: I started writing this before Fitch downgraded Spain and the Euro dropped a few cents but the point still holds.

originally posted by Jonathan Loesberg:
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.

There are prices here:

Loading…

futures.tradingcharts.com

They quote the "cash" Euro at $1.237 and various futures prices until 2011, for example at around $1.245 for September 2011. So the futures price is roughly equal to spot.

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?

If you wanted to speculate you could sell a futures contract on the futures market. [And I am not a lawyer nor a registered financial advisor edc. etc. so everything below is an academic example and not a recommendation.]

The short answer to your question is that there are buyers on the market right this instant who are buying at $1.245. You do not need to seek out an individual because given the forward/spot price relation enforced by arbitrage there is plenty of demand for Euro futures at the going price.

You would call up a futures broker, and sell 125,000 Euros for say September 2011 (this is the size of one contract). You would put a few thousand as a deposit in a margin account. Someone else would be on the other side of the transaction (you sell the contract to someone else). The other person would make a similar deposit. As the Euro rose you would have to put more money in the account; as the Euro fell, the other guy would put money in. In September 2011 you two would settle up and you would gain if the Euro were below $.245 and he would gain if it were above. Or you could cover and close your position earlier, buying back your position from someone else.

 

[Cole Kendall]

originally posted by SFJoe:

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.

Over my head by at least a foot.

It's not a term I hear used unselfconsciously by people ITB. But I am off in my own little world.

What people call themselves differs across financial markets; at least for a while there were "specs" in the futures markets. But academic taxonomists try to call things by what makes sense to them and not what the things call themselves.

 

[Jonathan Loesberg]

originally posted by SFJoe:

The current exchange rate contains the result of that argument. Offers to sell at non-market prices are either too high (cheaper in the market, so no trade) or too low (instantly hit by some trading computer and the profit pocketed in milliseconds), money just given away.

If everyone agreed that the euro was going to fall over the coming months it would already have done so.

The difference between forward and spot rates will be low because short term interest rates in both dollars and euros are low.

I'm going back to my day job now.

I may need to go back to school but this cuts to the chase to fast. The current exchange rate effects an ground between disagreements; it surely can't be the actual result or the price wouldn't fluctuate. The situation should be the same as for stocks. Two people who had disagreements about where the price would be a year from now would surely want to bet on that disagreement just as they can with stock prices. Why don't they?

In terms of my situation, the problem with looking at it from the perspective of a symmetrical market exchange is that that exchange doesn't capture the reality of one side's choice. Let me do a worksheet version with near real world numbers:

I want to buy 4,000 euros with cash I have in a bank account for that purpose (like all human beings, I have some liquid cash lying around for various purposes). I don't know what the 90 day forward differential is, but let's suppose it's half a cent higher than today's rate. That means, if I buy the 90 day forward, the euros will cost me $20 more than they do if I buy them today. Of course, I get to keep my money in a bank at .5% yearly interest or roughly $5 for the three months, so the actual difference is only $15. That's still $15 without regard to some guy in Avignon, or the cost of goods and services in three months, all of which will not change the amount of cash I have to spend and what I will get. And of course, if the forward is half a penny lower, it pays me $20 plus $5 to buy the forward (my French checking account does not get interest; there policies regarding checking accounts being stingier than ours), also without regard to some guy in Avignon. Unless you can explain to me how my dollar calculation is wrong, my money situation is unchanged by the state of his money situation.

There will of course be an economic explanation for this effect that makes it all come out in the end, but it won't come out in the end for me, nor can it. I have always assumed that one of the things that causes prices differences in the market is precisely that the cost to individuals does not always reflect the cost the markets figure in and individuals will take advantage of that. Obviously, the market evens those differences out over all individuals, but it doesn't even them out for each individual.

 

[Jonathan Loesberg]

originally posted by Oswaldo Costa:

originally posted by Jonathan Loesberg:

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?

If you need to buy EUR to make a payment in Europe in 90 days, you can buy it spot today for 1.24 (representing a bet that the Dollar will weaken) and invest it for three months and earn, say, one cent of interest or you can buy a 90 day forward for 1.25 (also representing a bet that the Dollar will weaken). These are equivalent transactions. If you thought the EUR was going to fall to parity, you would sell a 90 EUR forward at 1.25 (minus bid/ask spread) and then buy it back after 89 days at whatever the price is then (spot + one day interest).

You will see by my example above that this is simply an inaccurate description of my actual choices because its assumptions about the interest rates I will get by banking Euros or banking dollars are incorrect.

 

[Oswaldo Costa]

The interest rate used to calculate the forward/future premium/discount is the risk-free rate of each currency, i.e. treasury bills of each central bank. For your real life example above, you would have to use your Euros to buy French govt. 90 day paper, thus approximating the yield used to calculate the premium.

If you can't buy such paper with 4000 Euro and have to settle for checking account interest rates, obviously you will get hurt, but that doesn't change the principle that the forward rate is impervious to supply & demand or expectations for price behavior. That only affects spot.

 

[Jonathan Loesberg]

Cole,

Differentials in future prices in stocks are much higher. You are telling me that the current futures range of betting is only half a penny. My example caused a much larger difference. Differences between future and present costs of stocks run much higher because people bet on outcomes that are much more different. I'm happy to accept that this does not happy in the currency exchange market, but I wonder why. Are currency arbitrageurs just wooses?

I realize that one thing I'm saying may be incorrect. Although I have never traded futures, family members have. But they haven't done so for some years. It is perhaps the case that futures prices in stocks are less variant from current prices than they used to be.

 

[Tom Glasgow]

originally posted by Jonathan Loesberg:
Cole,

Differentials in future prices in stocks are much higher. You are telling me that the current futures range of betting is only half a penny. My example caused a much larger difference. Differences between future and present costs of stocks run much higher because people bet on outcomes that are much more different. I'm happy to accept that this does not happy in the currency exchange market, but I wonder why. Are currency arbitrageurs just wooses?

I realize that one thing I'm saying may be incorrect. Although I have never traded futures, family members have. But they haven't done so for some years. It is perhaps the case that futures prices in stocks are less variant from current prices than they used to be.

Have you wikied interest rate parity?

 

[Cole Kendall]

originally posted by Jonathan Loesberg:
Cole,

Differentials in future prices in stocks are much higher. You are telling me that the current futures range of betting is only half a penny. My example caused a much larger difference. Differences between future and present costs of stocks run much higher because people bet on outcomes that are much more different. I'm happy to accept that this does not happy in the currency exchange market, but I wonder why. Are currency arbitrageurs just wooses?

I realize that one thing I'm saying may be incorrect. Although I have never traded futures, family members have. But they haven't done so for some years. It is perhaps the case that futures prices in stocks are less variant from current prices than they used to be.

Here I am at a loss; currency prices (both spot and forward/futures) jump around all over the place. The manly (non-woos) currency traders force the futures price to move along with the spot price at any instant by arbitraging.

What do you mean by stock futures? Stock index futures are tied to stock index prices by the same mechanism that ties currency futures to currency spot prices. When the stock markets are closed, futures prices are all over the price but there are arbitrageurs who make sure that futures prices and stock spot prices are within a whisker of each other at any instant. Now it is harder to arbitrage say the S&P 500 index future with the 500 underlying stocks than it is with Euros but I am not sure if this is your point.

 

[Jonathan Loesberg]

originally posted by Oswaldo Costa:
The interest rate used to calculate the forward/future premium/discount is the risk-free rate of each currency, i.e. treasury bills of each central bank. For your real life example above, you would have to use your Euros to buy French govt. 90 day paper, thus approximating the yield used to calculate the premium.

If you can't buy such paper with 4000 Euro and have to settle for checking account interest rates, obviously you will get hurt, but that doesn't change the principle that the forward rate is impervious to supply & demand or expectations for price behavior. That only affects spot.

But our argument was precisely about first my situation and second that of wine importers, who I expect are in situations analogous to mine (they don't buy government bonds, they buy currency; if I'm wrong about this, I then withdraw that argument). It wasn't about bankers trading with each other. And, so, of course, it does change the principle with regard to such individuals.

 

[Ian Fitzsimmons]

It's not a term I hear used unselfconsciously by people ITB. But I am off in my own little world.

Oh, in my little world, I meant the financial cognoscenti.

 

[Jonathan Loesberg]

originally posted by Cole Kendall:

originally posted by Jonathan Loesberg:
Cole,

Here I am at a loss; currency prices (both spot and forward/futures) jump around all over the place. The manly (non-woos) currency traders force the futures price to move along with the spot price at any instant by arbitraging.

What do you mean by stock futures? Stock index futures are tied to stock index prices by the same mechanism that ties currency futures to currency spot prices. When the stock markets are closed, futures prices are all over the price but there are arbitrageurs who make sure that futures prices and stock spot prices are within a whisker of each other at any instant. Now it is harder to arbitrage say the S&P 500 index future with the 500 underlying stocks than it is with Euros but I am not sure if this is your point.

This answers the question. It also adds a new wrinkle. If forward prices, like currency prices, jump all over the place, indeed one can speculate within a wider range than is being suggested, even if only by moving faster. One can also, I assume, put in a bid at whatever price one thinks one might get from someone? So the market in fact fluctuates but only for those who engage in bidding?

 

[Ian Fitzsimmons]

I'm kind of sorry I asked about this now, I didn't think the topic was this complicated.

One thing I've learned: I wouldn't want to cross Oswaldo at a dark trading desk.

 

[Ian Fitzsimmons]

originally posted by SFJoe:

....

If everyone agreed that the euro was going to fall over the coming months it would already have done so.

....

Rational expectations! There's a joke about this: two economists are walking down a side walk when one exclaims: "Look, someone's dropped a $20 bill!" As he stoops to pocket the money, the other one says "Don't bother, someone's already picked it up."

 

[Cole Kendall]

originally posted by Jonathan Loesberg:


This answers the question. It also adds a new wrinkle. If forward prices, like currency prices, jump all over the place, indeed one can speculate within a wider range than is being suggested, even if only by moving faster. One can also, I assume, put in a bid at whatever price one thinks one might get from someone? So the market in fact fluctuates but only for those who engage in bidding?

Spot prices move every instant; there are people trading roughly 24 hours a day from Monday morning in Asia to Friday afternoon in the US. At any instant there is a spot price of the Euro/$ and a forward price that move together in lock step (except on the odd occasions when interest rates change).

So you can trade futures buying any time you want, at the market price and then selling whenever you want at the market price. You are trading small amounts so your trade will not move prices. At any given instant there are plenty of buyers and sellers willing to trade at the current price.

When there is an imbalance between buyers and sellers (say when Fitch cut the ratings on Spanish debt a few hours ago which was seen as bad news for the Euro), then there were lots of new sellers at the going price and not many buyers and prices dropped. Futures prices will move at exactly the same time as the spot prices.

 

[MarkS]

originally posted by Jonathan Loesberg:
blah...blah blah...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....blah...yada yada...blah balh...

Look, I've got a 'Quick 'n Dirty' solution for you: if you want to lock in a price NOW, whip out the VISA and click 'purchase' and let the big boys at the banks figure out all this complex-future-hedging-speculation business.

 

[Jonathan Loesberg]

originally posted by MarkS:

originally posted by Jonathan Loesberg:
blah...blah blah...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....blah...yada yada...blah balh...

Look, I've got a 'Quick 'n Dirty' solution for you: if you want to lock in a price NOW, whip out the VISA and click 'purchase' and let the big boys at the banks figure out all this complex-future-hedging-speculation business.

This is why you aren't my financial advisor.

 

[MarkS]

originally posted by Jonathan Loesberg:

originally posted by MarkS:

originally posted by Jonathan Loesberg:
blah...blah blah...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....blah...yada yada...blah balh...

Look, I've got a 'Quick 'n Dirty' solution for you: if you want to lock in a price NOW, whip out the VISA and click 'purchase' and let the big boys at the banks figure out all this complex-future-hedging-speculation business.

This is why you aren't my financial advisor.

Never said I was. I only give out sage wine advice, which also promptly gets the wave.