Recommended Buy (Entry)/ at 25% LevelswS,s>
 
points. By entering after 25% of the anticipated move has occurred and exiting 25% beforethe target, there is ample time to determine that the downward reaction has ended beforeyour long position is taken and enough caution to exit well before the next reaction. A crit-ical point in each main trend is midway between the start of the move and the target. If themidpoint is not reached, there is a change in direction of the main trend causing a reeval-uation of the main trend and the reactions. A change of direction is considered conclusiveif a reversal equal in size to 25% of the last reaction occurs during what was expected to bean extension of the main trend. That 25% value becomes the trailing stop-loss on any tradein the event the objective is not reached.
This discussion is not intended to be a complete representation of the Trident System,but a brief description of its essential ideas. The actual system has substantial refinementsand subtleties in target selection for major and minor trends and corrective moves; itincludes points to reverse positions based on the trailing stop.
In a later bulletin to Trident users, it was suggested that a modification to the systembe implemented with respect to money management. Using a technique similar to theMartingale System, each loss is followed by an increase in the number of positionstraded. The trader only has to continue to extend his positions and stay with the systemuntil he wins. A comprehensive version of this classic gambling approach can be foundin the section “Theory of Runs,” in Chapter 17. The Trident concepts are all reasonableand generally accepted by experienced traders. They include advance and retracement,trade the trend, don’t pick tops and bottoms, take the center out of each move, and usea trailing stop.
Rethinking Retracements
Interesting observations were made by Tom DeMark" about identifying the price movethat serves as the basis for measuring retracements. If the market is currently at a low,rather than judging the distance of this drop from the most recent swing high, he choosesto look for the highest point that has occurred since the last time the market traded at thislow level. He then finds the most likely retracement points using the Fibonacci ratios .618,and 1.618, plus Fibonacci alternatives .382, .50, 1.382, 2.236, and 2.618 applied to the dif-ference between the high and low, added to the current low price.
“Tom DeMark, “Retracing your steps,” Futures (November 1995). Also see Chapter 2 af DeMark, The New Scienceof Technical Analysis (John Wiley & Sons, 1994).298 CHARTING SYSTEMS
 
CHANNEL BREAKOUT -
The classic channel is formed by drawing a straight line along the bottom of an upwardtrend (or the tops of a downtrend), then constructing a parallel line that touches theextreme high price of that same time interval, forming an envelop, or channel, around aprice move. It is easy to do this with a chart and a ruler, but not as simple to transfer thisconcept to a computer program. Because the concept of a channel breakout is basic tocharting, an automated version may prove useful for identifying key market turning points.The steps to creating a program are as follows:
1. Create a swing chart to identify key high and low points. A construction of a swingchart was discussed in the first section of this chapter, “Finding the Swing High andLow Points.” This method used a minimum swing value, MSY, to identify a swing highor low. For example, once a price had declined from its recent high by the MSV, thatprevious high becomes the last swing high. The swing highs and lows are thereforeonly found after-the-fact. When a larger MSV is used, the points identified as swinghighs and lows become farther apart and are considered more important, or majorswings. By creating two swing charts using a small and a large minimum swing value,we can show both major and minor market price swings (see Figure 12-7). .
2. Find a straight-line trend. Beginning with the last swing high or swing low, use theleast-squares linear regression to find the straight line through the center of pricesthat have occurred since that high or low: .
Straight-line value Y = a x date + b
3. Draw channel bands. Beginnifig at the previous swing high or low, calculate thevalue Y of the linear regression line at all points up to the most recent date, and findthe two prices that are the farthest above and below the regression line. Theseprices will define the upper and lower channel bands: :
Highest relative price H max = Ht — (aPt + b)
Lowest relative price L max = (aPt + b) - Lt
 
FIGURE 12-7 Major and minor swings.
Major high
  
’Major low
    
Minor lows
Major lowCHANNEL BREAKOU+ 299
 
where @ and 6 are the linear regression slope and y-intercept. The channel band isfound by adding or subtracting H max and Z max from the linear regression straight-line formula:
Upper channel band = aPT + 6 + H maxLower channel band = aPt + 6 - L max
4. Project the bands one period ahead. To know whether the next price has brokenthe channel, indicating a change of trend, we project the channel one period aheadusing the slope value, a,
Projected upper channel band t+ 1=a@Pt+b+Hmax+aProjected lower channel band ¢ + 1=aPt+b—-Lmax+a
If the trend is up (the slope @ > 0) and the next price is below the projected lowerband, then the trend has turned from up to down. If the trend is down (@ < 0) andthe next price is greater than the projected upper band, then the trend has turnedup. When the slope, a, is very near 0, we have a sideways channel and the samerules still apply.
Because a major channel is considered a strong chart formation, prices that approachthe channel, but have not penetrated the band, would be candidates for trades. For exam-ple, if the trend is down and prices come within 15% of the upper band, we would wantadditional short positions (see Figure 12-8). We do not necessarily want to lift those exist-ing shorts at the bottom of the channel, especially if the downtrend is severe; however, this
 
FIGURE |2-8 Entering near the top of a declining channel. Points A, B, and C define the newchannel. Trades can be entered at point E/, exited at X/, then entered at E2 and E3 and exitedat X2,
 
 300- CHARTING SYSTEMS
 
technique offers a clear and safe way to scale into a trade with more than one entry point.If the trend is sideways (the slope is near zero), then exiting shorts and reversing your posi-tion could work well.
A minor channel can also be used to signal buys and sells within a major channel. Byfinding swing points using a small minimum swing value, we can wait for a break of theminor channel to signal a trend direction within the major channel. This gives an addedconfirmation that prices are moving in your direction before entering.
MOVING CHANNELS
As computers have become common, channels are frequently constructed as movingbands around prices. Some of these, such as those using a standard deviation, can claimstatistical significance (these are discussed in Chapter 5). A simple mathematical way ofrepresenting a channel might use the average of the high, low, and close to designate thecenter and a band based on the highs and lows. The midpoint of the price move M andheight or range R of the move can be calculated
aMe= Sy Dit et C)
12Ray 2 Gh)Then, the upper and lower channel bands forecasted for the next day areUi. =M, + (M, —M,-1) + wR,Tin. = M, + (My, ~ My -1) — wR,The bands are created by extrapolating the average midpoint and adding or subtracting theaverage daily range R multiplied by a scaling factor w. A long position is taken when thenew price P,,, > Uj,,; a short is taken when P,,, < L;,,. If a channel profit objective is
needed, it can be,calculated at a point equal in distance to the channel width from thechannel breakout as follows
Long objective U0, 41 = Uta + 2WR,Short objective LOr 4, = Li, ~ 2WR,
Because the value wR, represents one-half the band width, 2wR,, the objective is anequal band width above or below the breakout point on any day. The objective may remainfixed at the price level determined on the day of the breakout, or preferably, will changeeach day to remain one band width from the new channel value (Figure 12-9). This methodrelates closely to volatility measures and more examples can be found in Chapter 20.
An alternate way of defining a channel would be to forecast 1 day ahead using theslope of a regression analysis (/inear for a straight channel, /og for a curved one) and usethe standard deviation of the price changes to define the band. The other rules wouldremain the same.
’
COMBINING TECHNIQUES
Richard D. Wyckoff, popular in the early 1930s, relied solely on charts to determine themotives behind price behavior. He combined the three most popular methods, bar chart-
+ For a further discussion of channels, see Donald Lambert, “Commodity Channel Index: Tool for Trading CyclicTrends," Technical Analysis of Stocks & Commodities (October 1980), and John F. Ehlers, “Trading Channels,”Technical Analysts of Stocks & Commodities (April 1986).COMBINING TECHN. | JES 301
 
ing, point charts (the predecessor of point-and-figure charts), and waves to identify thedirection, extent, and timing of price behavior, respectively.'®
To Wyckoff, the bar chart combined price and volume to show the direction of theprice movement. In general terms, it shows the trading ranges in which supply anddemand are balanced. The volume complemented this by giving the intensity of trading,which relates to the quality of the long or short position. Wyckoff used group charts, orindices, in the manner of Charles Dow, to select the stocks with the most potential, ratherthan looking only at individual stock price movement. This assures that the move is basedon the broader nature of the business, rather than on company politics.
Point-and-figure charts are used to condense price action. If prices move from lower tohigher levels due to events, the time it takes to reach the new level is unimportant. Point-and-figure charts record events, not time. As long as prices rise without a significant rever-sal, the chart uses only one column; when prices change direction, a new column is posted(see the point-and-figure section of Chapter 9 as well as the swing trading section of thischapter). Price objectives can be determined from formations in a point-and-figure chartusually related to the length of the sideways periods or horizontal formations. Theseobjectives are very different and normally closer than objectives found using similar barchart formations.
The wave chart, similar to Elliott’s theories, represents the behavior of investors andthe natural rhythm of the market. Wyckoff uses these waves to determine the points of buy-ing and selling within the limitations defined by both the bar chart and point-and-figurecharts. He considered it essential to use the wave charts as a leading indicator of pricemovement.
Wyckoff used many technical: tools but not rigidly. He did not believe in unconfirmedfundamentals but insisted that the market action was all you needed—the market’s pri-mary forces of supply and demand could be found in charts. He did not use triangles, flags,and other formations, which he considered to be a type of Rorschach test, but limited hisanalysis to the most basic patterns—the horizontal or congestion areas. He used time-
'6 Jack K, Hutson, “Elements of Charting,” Jechnical Analysis of Stocks & Commodities (March 1986).
 
FIGURE 12-9 Channel calculation. ~
     
2wR ™ Breakout objective (UO).
wR Upper band (Uj)
- Daye302" CHARTING SYSTEMS
 
based and event-based charts to find the direction and forecast, then relied on humanbehavior (in the form of Elliott waves) for timing. His trading was successful and his prin-ciples have survived.
COMPLEX PATTERNS
Most charting systems involve a few simple rules, trying to model a price pattern that seemsto have repeatedly resulted in a profitable move. The most popular systems are simply abreakout of a previous high or low, either a horizontal pattern or a trend channel. Over theyears these approaches have proved to be steady performers. Another group of tradersmight argue that it is better to be more selective about each trade and increase the expecta-tion of a larger profit, than to take many trades to win with the long-term probabilities.
DeMark’s Sequential™
Tom DeMark has created a strategy, called a sequential, that finds a very overextendedprice move, one that is likely to change direction, and takes a countertrend position.” Hisselling objective is to identify the place where the last buyer has bought. His rules use.counting and retracements rather than mathematical formulas or trendlines. To get a buysignal, the following steps are applied to daily data:
1, Setup. To begin, there must be a decline of at least nine or more consecutive closesthat are lower than the corresponding closes 4 days earlier (close ~ close[4] < 0). Inthe case where today’s close is equal or greater than the close 4 days before, thesetup must begin again.
2. Intersection. To assure that prices are declining in an orderly fashion, rather thanplunging, the high of any day on or after the 8th day of the setup must be greater thanthe low of any day 3 or more days earlier. Note that there can be a delay before the in-tersection occurs provided that the pattern is not negated by the following rules.
3. Countdown. Once the setup and intersection have been satisfied, we count thenumber of days in which the close was lower than the close 2 days ago (close <close[2]). The days that satisfy this countdown requirement do not need to be con-tinuous. When the countdown reaches 13 we get a buy signal unless one of the fol-lowing conditions occurs:
a. There is a close that exceeds the highest intraday high that occurred during thesetup stage.
b. A sell setup occurs (nine consecutive closes above the corresponding closes 4days earlier),
c. Another buy setup occurs before the buy countdown is complete. In this case, therules begin again at Step 2, the intersection. This condition is called recycling.
For the sequential pattern, the sell signal is the reverse of the buy. Traders should expectthat the development of the entire formation will take no less than 21 days, but typically 24to 39 days. _
Entering the Sequential ’Once the buy signal occurs, there are three choices for entering the-market. The first is toenter on the close of the day on which the countdown is completed; however, this risks anew setup situation that will extend the conditions for an entry. The second requires adirectional confirmation, the close greater than the close 4 days ago, but it avoids the pos-sibility of recycling. The third is to enter a long when tbe close is greater than the high 2days earlier, a compromise between the first two techniques. -
7 Thomas R. DeMark, The New Science of Technical Analysis (John Wiley & Sons, 1994).COMPLEX PATTERN. - 303
 
 
FIGURE 12-10 A sequential buy signal in the Deutschemark.Deutsche Mark
 
cent | 4
sot pl... fo geee sees el | oo
°
0.5220} . seg the eee Fe Pe eee
28oF—SS=>—=
°=?
 
 
°
“asaak co, a
 
 
B.492b ee EN eefe x nee Cn ne DOS OS OO10 24 8 22 5 cy 3 qq 31 44Apr 1989 May Jun dul Aug
 
Source: Logical Information Machines, Inc. (LIM), Chicago, IL.
Exiting the Sequential
A number of exit conditions, consistent with the type of patterns, provide the trader withclear rules to liquidate the current trade. First, the current buy setup is complete, and thelowest price recorded does not exceed the furthest price recorded by the recent inactivesetup (normally the previous sell setup). If, on the other hand, any price recorded in thecurrent buy setup exceeds the furthest price of the previous sell setup, then the position isheld until a reverse signal occurs.
Two stop-losses are also recommended. For a buy signal, the true range for the lowest-range day of the combined setup and countdown period is subtracted from the low of thatlowest day to create a stop-loss. Alternately, the difference between the close and the lowof the lowest day is subtracted from the low of the lowest day to form a closer stop-loss.
Considering Complex Patterns
There seems to be an extreme contrast between the simple robustness of a breakout sys-tem and the very complex set of circumstances that produce a signal for DeMark’s sequen-tial. The philosophic consistency of the breakout system is demonstrated by applying304 CHARTING SYSTEMS.
 
increasingly larger breakout criteria to the same market and observing that the reliabilityand profits per trade both increase, indicating that it becomes more selective, and thosetrades that occur have a better performance profile. In the case of a single pattern, such asan island reversal or DeMark’s sequential, there is no way to measure this robustness. Forthe sequential, the time taken to identify a signal must also limit the number of signals thatare possible. Each wader must decide whether this pattern selection produces a better setof trades, or if it is too demanding to survive the test of time.| 3
Spreads and Arbitrage
 
shares is called a spread, or straddle. When the dynamics of the spread can be defin-
itively calculated, such as the price of two bonds of the same maturity and the samegrade, or the price of gold in two different locations, the transaction can be considered anarbitrage. For futures markets, the most common use of the term spread relates to twodelivery months of the same market. For example, a trader may take a long position inMarch Treasury bonds and a short position in the June contract (for the same year). Theexpectation is that prices will rise and that near-term delivery will rise faster than thedeferred, netting a larger profit om the long position and a smaller loss on the short.
A spread is most often a way to reduce both the risk and, consequently, the potentialprofit that exists in an outright long or short position. A spread is commonly placed in twodelivery months of the same market, a combination of futures and physicals in the samemarket, or in two options of different strike prices or maturities. The reduction in riskdepends on the relationship between successive delivery months, which varies consider-ably with the market traded. These can be summarized as follows:
A position taken in opposing directions in related markets, contracts, options, or
Financial markets nearest to delivery react more quickly and with greater magnitudeto changing interest rates, economic data, and supply and demand situations. Thedeferred contracts will respond more slowly because the lasting effect on the market isnot as clear.
Precious metals, such as gold, platinum, and silver, were once considered pure carrymarkets. Successive delivery months would always trade at a higher price due to theinterest rate component of holding inventory. If the price of the metal rises or interestrates rise, the cost of carry increases and the spread between months widens. If metalprices or interest rates decline, the spread narrows. If metal prices and interest ratesmove in opposite ways, the effect on the spread is dampened to varying degrees. Therehas been an evolution in the industrial use of precious metals, primarily in electronics,which has increased the consumption and changed the patterns to reflect a moreindustrial look. _Industrial metals, such as copper, will show normal carrying charges under most cir-cumstances, but they are affected by demand to the extent that prices have beenknown to invert for significant periods of time. Because of their fundamental changes,silver prices inverted for the first time in 1997.
Foreign exchange rates are dependent on the prevailing economic outlook for the spe-cific country, combined with their balance of trade. A stable economy will show nearlyunchanged forward rates; a weakening economy will cause the deferred contracts tobe discounted. Prices tend to become more volatile as they move away from equilib-rium, whether higher or lower. Because exchange rates are quoted in terms of othercurrencies, everything must be viewed as relative to another economy.
Agricultural products (crops) contain a well-defined carrying charge within each cropyear. Expected variations in both supply and demand have made delivery month pat-306 SPREADS AND ARBITRAGE
 
terns differ from one another; however, prices rarely achieve full carry. (Note thatpotatoes are an exception to the normal patterns shown by agricultural products.)
Livestock markets are noted for products that cannot be stored and redelivered; there-fore, the prices for any one contract month are based on anticipated supply anddemand at the time of delivery. Feedlots and farmers have been known to deliver earlywhen prices were high or when production costs were rising, however, this will causean unreplaceable shortage in the nearest deferred months (Figure 13-1),’ Patterns in
‘Perry J. Kaufman, “Technical Analysis,” in The Handbook of Financial Futures, Nancy H. Rothstein (ed.),(McGraw-Hill, New York, 1984).
 
FIGURE 13-1 Interdelivery price relationship and terminology. (a) Precious metals. (b) Indus-trial metals. (c) Foreign exchange. (d) Agricultural products. {e) Interest rates.
 
DeliverSpot ———““"" —» Deterred
{a). Precious metals*Price incregse results in spread increase.‘Rate increase results in spread increase,
“Contango”
Price —>
iagerest (ate
 
(b). Industrial metals*Under normal conditions carrying char gesact as in precious metals.*Extremedemand can cause backwardationin the near-term contracts.
Price —~
   
‘Contango
tc). Foreign exchange‘Normal market reflects prevailingeconomic outldok.*Economic changes could cause near-term \or deferred to move to a premium.
Price———
 
(d}. Agricultural productsNormal carry applies during 1+ crop year under normal circumstances.inverted markets are the result ofextreme supply shortages.
Price——>
 
conditions,“Negative carry occurs during periodsof economic instability.
Yield-—>
 
 
 
Increasing maturity—~ARBITRAGE 307
 
delivery months are a combination of livestock on feed, expectations of marketing, andthe price of grain.
Spreads are actively traded between related products. As within a sector of the stockmarket, such as airlines or technology, there are groups of financial and agricultural marketsthat are interdependent. Globalization has made interest rates in the industrialized coun-tries respond to changes in monetary policy by the United States, Germany, and Japan.Changing interest rates then cause changes in foreign exchange rates, which also impact thelocal equities markets. The meetings of the Group of 7 (G7) further increase the chance ofa unified policy by setting common expectations among the largest economies. While thereis a clear dependence of one market on the other, the effects are highly variable.
Spreads are often unique to a specific market situation and cannot be generalized forall products. The trader must first understand the basis of the spread relationship beforeany technical analysis can be applied. It is most important that a trader understand the con-ditions under which a spread, or even an arbitrage, will fail. This chapter will present manyapproaches to spreading that very specific; examples are equally limited in scope andapplication.
SPREAD AND ARBITRAGE RELATIONSHIPS
The relationship between two markets, or between various deliveries and trading vehicleswithin the same market, will determine the type of trading strategy that may be applied.The types of spreads and arbitrage situations that are most often watched are;
1, Substitute products, such as wheat and corn or cattle and hogs. Product substitu-tion ranges from those markets that are nearly identical (e.g., 3-month T-bills and 3-month Eurodollars), to cotton and soybeans, which share the same land andgrowing season.
2. Location spreads, including gold in New York, Chicago, and London; cocoa andheating oil (gasoil) in New York and London.
3. Carrying charge spreads and cash-and-carry, where one delivery month is out-of-line with others.
4. Product relationships, such as crude oil versus heating oil and gasoline, and soy-beans versus soybean meal and oil.
5. Usage spreads, including the hog-corn ratio, feeder cattle-corn-fat cattle, cocoa-sugar, broilers-corn, and lumber-plywood.
6. Pure price differences, such as exchange and interbank currency rates, interest ratesof the same maturity and the same grade, where there is no actual cost of deliveryor carrying charges.
ARBITRAGE
When the two legs of a spread are highly correlated and, therefore, the opportunity forprofit from price divergence is of short duration (less than 1 or 2 days), the trade is-calledan arbitrage. True arbitrage has, theoretically, no trading risk; however, it is offset by small_profits and limited opportunity, For example, a spacial arbitrageur using the interbankmarket might call one bank in Tokyo and another in Frankfurt to find their rates on theMexican peso. If they differ, the trader would buy the peso from one bank and sell the pesoat another provided:
1. The price difference was greater than the bid-asked spread, representing the cost ofconverting the currencies, .2. The arbitrageur has proper credit established with both banks,308 SPREADS AND ARBITRAGE
 
3. The transaction can be performed simultaneously (by telephone). This requiresone trader with a telephone in each ear or two traders working side-by-side.
Large-scale arbitrage has become the domain of major financial institutions whoemploy many traders, each provided with high-tech computer displays, sophisticated ana-lytic software, and lots of telephones. These traders specialize in specific interest rate mar-kets, foreign exchange, individual stock selection, or less often, precious metals. Theyconstantly scan quotes from across the world to find price differences, then act quicklyusing cash, forward and futures markets. They trade large quantities to profit from smallvariations. For the interest rate markets, there are computer programs that compare thevarious types of coupons and maturities to identify an opportunity quickly. Such opera-tions have become an integral part of the banking industry, they keep rates in-line withother banks and generate steady profits.
Pricing of Futures Contracts
The relationship of one futures market delivery month to the spot price of that market isdifferent according to the type of product, which has already ‘been described in generalterms. The mathematics of some of these relationships can become very complex, and thereader is referred to texts that deal specifically with these subjects.” The following sectionsdescribe the most important features of these relationships.
Storable Commodities
Storable commodities can be purchased in the cash market, stored, and sold ata later time.They can also be delivered on a futures contract, held in storage, and redelivered againstanother contract. This puts an upper limit on the amount of the carrying charges that canbe added to futures prices. The difference in cost between holding the physical commod-ity and buying it on the futures market are:
1. The financing cost involved in the purchase of the physical commodity:added interest cost = spot price ({1 + interest rate}! fares contract _ 1)
Where life of futures contract is expressed in years. \
2. The cost of storage, if any.
3. Aconvenience cost for not buying the physical product, and the ability to be able toSell it at any time.
These three costs are added to the futures spot price to get the fair value of the futuresprice at the time of delivery. The strategies that keep the spot and futures prices aligned,where F is the futures price, S is the spot price, r is the annualized interest rate, t is the lifeof the futures contract (in years) from today to the time of delivery, and & is the net annualstorage cost (expressed as a percentage of the spot price) are:
Method 1: Buy the futures contract for F, take delivery at expiration. Margin cost canbe collateralized. Net cost is F
Method 2: Borrow the cost of the spot commodity S and buy the physical product; paythe interest, S({1+r]‘~ 1), and the storage net-ofconvenience cost, 5 x k x ¢, until thecorresponding futures market delivery.
* See Aswath Damodaran, Investment Valuation (john Wiley & Sons, New York, 1996, pp. 448-458), which pro-vided the basis for these formulas; also see Marsha Stigum, Money Market Calculations (Dow Jones-Irwin, 1981).ARBITRAGE ~ 309eeeThe two methods must have the same net cost; otherwise, everyone would choose thecheaper alternative. Therefore the two strategies are equal, and they form the basic arbi-trage relationship between futures and spot prices:
F=S+S({1tr}—1) + Skt=S((1 +r} + kp)
This relationship represents the ideal case. If you add more realistic features, includingseparate borrowing and lending rates, r, and rz, where r, > ra, and assume that the shortseller cannot recover the saved storage costs and must pay transaction costs, f,, as well, youget a normal range in which futures prices can fluctuate:
(S-t)( +1) < F< Sl +r5)'+ kD
When futures prices move outside this range, there is a possibility of arbitrage.
Interest Rate Parity
One well-known, second-order arbitrage combines foreign exchange forward rates withinterest rate parity. Consider the following: A U.S. corporation would like to invest $1 mil-lion for the next 6 months. The current U.S. T-bill return for the next 6 months is lower thanthe rate in West Germany, and the inflation rate is about the same. The corporation is facedwith the decision of whether to convert U.S. dollars to Deutschemarks and invest in WestGerman time deposits or accept the lower U.S. rates. The decision is made easier if the cor-poration purchases goods from West Germany, since it must eventually convert U.S. dollarsto Deutschemarks to satisfy payments; the conversion cost will then exist with either choice.
What if the value of the Deutschemark loses 1% against the U.S. dollar during the 6-month investment period? A corporation whose payment is stated in Deutschemarks suf-fers a 1% loss in the total interest received. If the 6-month return was 4%, interest receivedis now valued at $400 less than the $40,000 total, a small amount for the corporation mak-ing payment in Deutschemarks. A speculator would face a different problem because theentire return of $1,040,000 would be reduced by 1% to $1,029,600, netting a return ofonly 2.96%, less the additional cost of conversion. For the speculator, shifts in exchangerates often overwhelm the relative improvement in interest rate return.
The interest rate parity theorem will normally explain the differences between the for-eign exchange rates and the relative interest rates of countries. It states that
the forward rate of a currency is equal to its present value plus the interest earnedin that country for the period of the forward rate.’
Using the futures or interbank market for the forward rate (DM, ,, is 1 year forward)and the spot rate for the current value (DM,,.,), the annual interest rate in West GermanyUcer) is applied to obtain the relationship
DM yr = DM por (1 + Leer).Because the forward value of the U.S. dollar can be expressed similarly asUS.1y¢ = US.spor (L + 1us)
Compute the implied interest rate/