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Article Directory :: Finance & Investment Articles
The weak dollar has become headline news. You can’t turn on a television business news program without hearing talk about the weak U.S. currency and how other markets are keying off of it. This has put the forex market in the limelight. Most forex trading takes place in the cash or interbank market, while it is also traded in the currency futures market. The purpose of this article is to show how currency futures prices relate to the cash forex market and how to convert forex futures to cash (spot) prices and vice versa.
How do forex futures trading prices relate to those in the cash forex market?
The most active currency futures trading contracts trade for four fixed dates in the year. They settle on the third Wednesday of March, June, September and December. In contrast to the futures market, the cash forex adjusts its maturity dates daily, trading primarily for monthly maturities of one, two, three, six and twelve months ahead, with the flexibility to quote for any individual date in-between. The interbank market thus trades for spot and forward delivery. The cash or interbank market is a delivery market. That means that all transactions between institutions must be settled for the full face value of each transaction.
In contrast to the cash market, forex futures trading markets allow traders to buy and sell contracts and thus avoid the need for the cash settlement of trades. Such is always available at the quarterly settlement of maturing contract allowing professional arbitrageurs to keep the two markets tightly in line with one another.
Currency Futures are spot prices adjusted by the forwards to arrive at a future delivery price. Professional arbitrageurs job the two markets to keep them in line.
Where then do the forwards come from?
Many mistakenly feel that forwards are the markets prediction of where spot prices will be at some point in time in the future. They are not. They are generated solely by interest rate differentials. For example, suppose a $/yen conversion rate is needed for one year away and the price must be fixed immediately. This can be accomplished by borrowing dollars for a year. Immediately converting them into yen and placing them in a one year time deposit. The yen deposit matures in twelve months and its proceeds at that time are used to meet the future yen commitment. The cost of the hedge is the loss on the interest rate differential. That interest rate differential can be applied to spot forex rates by converting them into point values. These point values are called forward swaps. Global-View provides forward swap values daily for converting spot to futures and vice versa as part of its forex resources section.
Example: US$ 12 mo deposit/lending rate 6.25% Yen 12 mo deposit/lending rate 0.50% Interest rate differential = 5.75% $/yen exchange rate 105.00 105.00* -0.0575=-6.038 points
Of course the transaction can be reversed to lock in a dollar value against the yen. In that case, yen would be borrowed and deposited into dollars. On that trade the transaction would earn 5.75%. If ever the forward market gets out of line with interest differentials, traders will quickly force them back into line by use of the deposit market. The market actively trades the forward point values. The IMM maturities (value dates) are now actively quoted in the interbank market, and are often determined by a straight line interpolation between the nearest actively traded value dates.
Quoting conventions in the interbank market and currency futures trading market(IMM):
Due mainly to historical precedent, dollar forex rates are quoted in one of two formats: 1) Dollar value of foreign fx currency unit. (e.g. one British pound is worth US$1.6050).
2) Number of per foreign forex currency units per dollar. (e.g. 105.00 yen purchase US$1.
The IMM quotes all currencies using convention #1. This convention allows point values to have a fixed dollar value. Using convention #2, point values would have a fixed foreign currency value. This would create a logistical nightmare for a dollar-based exchange as daily settlements would have to be converted to dollars using an arbitrary exchange rate. Convention #1 quotes are simply the reciprocal of #2, and vice-versa.
For example: $/yen 105.00 can be converted from #2 to #1 as follows. 1/105.00=.009524
Global-View posts indicative IMM swaps each trading day and can be found on its website.
Jay Meisler is a co-founder of Global-View.com, the leading forex discussion site for more than a decade and where traders from around the globe come for the latest breaking news, flows, rumors and trading ideas => http://www.global-view.com
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