affairs as a recession.Usually, however, these savings find their way back to the machine throughthe hands of businesspeople who borrow the funds from the people and re-injectthe money back into the spending flow by increasing the size of the machine, i.e.,building plants, or buying new equipment and inventory. Depending on how muchof the savings businesspeople want from people, they raise or lower the price(interest rate) they are willing to pay people for the use of their money. Theseactivities, which are analogous to modernizing and expanding the machine, create new jobs and increase total income, thus bringing the flows of spending backtoward a balance.201
Chapter 20
A second imbalance, or drain on the flows, can be caused by taxes collected by the government. Taxes are paid to local, state, and national governmentsand have the same slowdown effect that savings have. However, just as with savings, the tax money finds its way back into the system because the government hirespeople and buys goods and services.Just as increases in savings and taxes can create imbalances in the systemthrough withdrawals, imbalances also can be created by people refusing to save andsimply demanding more goods and services from the government. The government can either refuse the demands or pay for them by raising taxes or printingmoney, which is then given to the machine in payment for the goods and services. Refusing the demands and raising taxes are not always popular with the people; hence, governments frequently opt to print more money. Frequently, this is moremoney than is necessary to keep the machine running smoothly. In order to meetthis output, the machine foregoes repairs and hires untrained workers. All theincome is used to produce goods to meet current demand and none is used forexpanding, rebuilding, and updating the machine. This results in reduced efficiency. Ultimately, costs increase and the machine reaches the limits that it canproduce. To alleviate this, consumers need to be convinced to postpone their purchases. This is best done by raising prices. This is referred to as inflation. Hence,when too much money gets into the system, the result is inflation.
MONEY, THE MACHINE, AND THE BANKING SYSTEMIt should be obvious from the above that if the flows of money spending match theflows of goods and services produced, prices will remain stable and the machinewill run smoothly. If imbalances in flows of money occur, the machine slows downor works at such a furious pace it generates more momentum than it can handle.Thus, the amount of money and the smoothness with which it flows from individuals back to the machine through the land, labor, and capital become mostimportant in determining the health of the economy.In order to make this all flow smoothly in an economy, every country has abanking system through which they facilitate the flow of funds and adjust the supplyof money. Banks serve as depositories for people’s savings. They act as intermediariesby making these savings available to businesspeople for investment expenditures andthe vital function of furnishing business and government with credit. Through theirlending function, banks are able to adjust the money supply to make the flow of spending match the flows of goods and services, land, labor, and capital.Naturally, most governments do not allow banks to operate willy-nilly inthis system. Instead, the governments establish a central bank that acts to regulatethe actions of commercial banks and to manipulate the expansion and contraction
202
Financial Futures—An Introduction
of the money supply. Thus, the ultimate control of the money supply rests with thegovernment.In the U.S., the Federal Reserve Board (the “Fed”), through its network ofregional federal reserve banks, acts as the central bank. Its methods of operation differ only in degree from the central banks of other countries. The Fed operates tocontrol the money supply by controlling the amount of excess reserves in the banking system. Long ago, banks found it prudent to maintain reserves against theirdeposits in order to meet the normal cash withdrawals of their customers. Current federal law requires them to maintain certain minimum reserves. The amounts over andabove the minimums needed are called “excess” and are funds available for lending.The Fed controls excess reserves by these methods:a. Adjusting the required ratio of reserves to deposits. By lowering therequired reserve ratio, the Federal Reserve decreases the amount of reservesthat member banks are required to maintain in their accounts and makesadditional reserves available to the member banks. Thus, a reduction in therequired reserve ratio from 12 percent to 10 percent would increase theamount of excess reserves and thereby increase the amount of moneyavailable for lending. By raising the required ratio, the opposite wouldoccur.b. The purchase or sale of government securities, T-bills, bonds, etc. Whenthe government buys the securities, they increase member bank reservesand vice versa.c. Through loans of reserves to member banks.A commercial bank may be short on reserves relative to its demand for loansand may then borrow from the Federal Reserve. The bank will pay a rate of interest known as the discount rate. The Fed can set the discount rate at whatever levelit wants. By raising this rate of interest, borrowing is made more expensive and commercial banks will be less inclined to borrow reserves. They will have to raise therate of interest to customers, and as the price of credit to customers goes up, usually the demand for such credit will go down. Conversely, by reducing the discount rate, borrowing is made less expensive and banks will be more inclined toborrow reserves and make loans to their customers.Thus, the central bank of a government acts to regulate the actions of commercial banks and thereby regulates the supply of money to accomplish specificobjectives related to levels of employment, personal income, and price stability;i.e., they regulate the machine.The extent to which the central bank accomplishes these objectives has a greatinfluence on the interest rate price and the international price (foreign exchange rate)of a country’s money. The alert trader will closely watch the monetary policy of a
203
Chapter 20
country and the action taken with each of the monetary tools. They are among the mostimportant elements in determining long-term strength or weakness in a country.
INFLATIONMoney by itself is really useless. It takes on value only when it is used as a medium of exchange. Thus, the value of money lies in what it can buy.Twenty years ago, one dollar would buy a half-gallon of milk, a newspaper,and a package of gum. Today, it won’t even buy a Sunday newspaper. Ten yearsfrom now, it might buy more or less things.The dollar itself doesn’t change. It is still four quarters, 10 dimes, 20 nickels, or 100 pennies. But what the dollar will buy does change. How does thatchange affect the foreign exchange rate and domestic interest rates? The explanation lies mostly in inflation.Inflation in a country weakens the domestic purchasing power of the currency for the consumer in that country. People on pensions and others on fixedincomes find that their dollars buy less. People with savings accounts find thatinflation reduces the value of their savings.
The Inflationary ProcessMonetary economists trace the inflationary process through as follows: First, achange in the rate of the growth in the money supply causes a change in people’sincomes in the same direction about six to nine months later. This money “burnsa hole in the pocket” and people rush out trying to spend their extra income. Itusually takes about another six to nine months before this increased demand catches up with the available supply and prices start to rise. Thus, about a year to a yearand a half after the money supply increases, one can expect to see a rise in prices.The Consumer Price Index reflects the general prices of things people buy andthus it becomes the most handy means of measuring inflation. The extent to whichthe money supply is increased, of course, will affect the extent to which incomesincrease, which in turn will affect the amount of money people have to spend andtheir ability to bid up prices. So a small change in the money supply beyond theamount necessary to maintain economic growth, employment, and stable prices willprobably result in small amounts of inflation.
Inflation and Interest RatesInflation rates become important in forecasting interest rates because the expectations about levels of inflation get built into the price for borrowing money. Lookat it this way. Ten years ago, the dollar would buy a newspaper, a half-gallon of204
Financial Futures—An Introduction
milk, and a package of gum. Inflation (rising prices) has caused the domestic purchasing power of the dollar to decline so that today it takes two dollars to buy thesame amount and quality of goods. So, if you loaned someone a dollar 10 yearsago, and if the average annual rate of inflation was 10 percent, when that personpays it back today it is worth only about half as much as when you loaned it to him.If you had charged that person 5 percent per year interest, you would have collected50 cents in interest and, counting that, would find your dollar worth only about threefourths as much as 10 years ago.Had you anticipated the 10 percent average annual inflation rate, you wouldhave asked for at least a 10 percent interest charge in order to maintain your purchasing power over the 10-year period. More likely you would have asked for 15percent interest, reasoning that you expect that money to provide a 5 percent realrate of return after accounting for the 10 percent expected inflation. It is this latterway that businesspeople and bankers react. Thus, expected inflation rates get builtinto interest rates. That is exactly what happened in the late 1960s and late 1970s.
Inflation and Foreign Exchange RatesInternationally, the purchasing power of the currency may be reduced if the inflation rate in the home country is greater than that in other countries, assuming relative free trade. So the important consideration from a foreign exchange trader’sstandpoint is the relative rate of inflation. If Japan inflates faster than the U.S.,Japanese products will become more expensive for Americans. Further, Japanesewill switch from the higher-priced Japanese products to the lower-priced U.S.products. Thus, Japanese exports to the U.S. will decrease and American exportsto Japan will increase. All of this will reduce the demand for the Japanese yen andincrease the demand for the U.S. dollar.Therefore, you should closely watch the relative rates of inflation in the U.S.compared to the other countries of the world. If you see that U.S. inflation, compared to Japanese inflation, is consistently different and by a large amount, you cansee that ultimately the exchange rate between the two currencies is going to have tochange to reflect the reduced international purchasing power of the Japanese yen.When the exchange rate does ultimately change, it may or may not (more likely not)reflect the exact changes in the relative purchasing power of the two currencies.Of course, the relative rate of inflation is not the only factor to consider inforecasting exchange rates. It waxes and wanes, a major factor at times, and aminor factor at other times, being overshadowed by other events. Certainly, in theyears from 1945 to 1972, when the world was on a “fixed rate” system, the various governments’ determination to maintain a fixed exchange rate overshadowedthe impact of inflation rate differentials. Note: The next chapter will discuss theseand other basic elements of foreign exchange trading.205
Chapter 20
Thus, the money supply and rates of inflation become key elements in understanding and forecasting prices of foreign currency futures and interest rate futures.For early indicators of things to come in money supply trends, watch the action ofthe Federal Reserve Board, the Wholesale and Consumer Price Indexes, and fundamental economic reports (e.g., gross national product, employment, industrialproduction, etc.) released monthly by the various departments of the U.S. government.In summary, through the open, competitive futures market, the general public has an opportunity to make known its hopes, fears, and beliefs about the valueof a currency. And with daily reports from a futures exchange of trading volumeand price fluctuations, there is a public weathervane providing daily signals of thetrue value of a currency, giving the public a clearer insight into the effect that political actions, monetary policies, balance of trade, and other factors have on the economics of world commerce. All of this, of course, provides for differences of opinion and trading opportunities.
206
Chapter 21
Money—Tradingthe Ultimate Commodity
If you buy a pound of cheese from Wisconsin or a gallon of wine from California, younaturally pay for it in dollars. The cheese manufacturer and the wine producer expectto be paid in dollars because their expenses and living costs are all settled in dollars.Within the U.S., such single-currency transactions are made without a second throught.On the other hand, if you want to buy an English topcoat directly from theBritish manufacturer, matters get more complicated. You must pay in British pounds(pounds sterling) rather than in U.S. dollars. Similarly, an English person desiringWisconsin cheese must somehow get U.S. dollars to pay the American producer,if he wants to buy the cheese directly. Most Americans have never seen a Britishpound note and would understandably be reluctant to accept it as payment if theycould not be sure of converting it into U.S. dollars.Clearly, then, if such transactions are to occur, there must be some meanswhereby the American who desires to get pounds sterling to pay for a topcoat canconvert his or her dollars into British money and vice versa for the English person who wants to buy Wisconsin cheddar.207Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 21
Simply stated, the conversion of one money into another is the sale of onecurrency for another. Money is treated like any other commodity. It is bought andsold at a price. This price is called the foreign exchange rate.Thus, when you read that the foreign exchange rate for the deutschemark is$.4500, this means that the price of one deutschemark is 45 cents in U.S. dollars.Very often, you see headlines that announce the dollar is “weak” or some othercurrency is “strong.” When the dollar is said to be weak, this means that people areselling the dollar and buying other currencies; that is, the dollar price of the other currencies has increased. For example, if the price of one deutschemark goes from 52cents to 53 cents, the dollar has weakened and the deutschemark has strengthened.This chapter will explain some of the basic elements of the foreign exchangemarket, including why it exists and how it works. It will cover some of the fundamental aspects of foreign exchange, including a discussion of the recent history of the international monetary system, the development of the futures market inforeign exchange, the economic indicators that help you analyze the relative strengthor weakness of a particular country’s currency, and some very basic introductoryconcepts about hedging in foreign exchange.
THE PRICE OF MONEYForeign exchange transactions are usually done through a foreign exchange traderlocated at a bank. Modern-day foreign exchange dealings became common with thedevelopment in 11th century Europe of the Champaigne fairs where merchants boughtand sold goods in their counterparts’ currencies. Bankers attended the fairs to act asmoney changers, the modern-day equivalent of the foreign exchange trader.The price of a currency is determined in the same way you determine theprice for any other commodity—by the forces of supply and demand. If the people in the U.S. begin to demand more English-made products, the demand for thepound sterling goes up; as the demand for the pound sterling increases, Americanswill have to pay higher prices in order to induce holders of sterling to sell.Conversely, if the British developed an overwhelming taste for U.S. goods, theywould have to sell more and more pounds sterling for the U.S. dollars to pay forthe products they bought. This increase in the supply of sterling being offered forsale would cause the price to drop relative to dollars.
RECENT HISTORY OF THE INTERNATIONALMONETARY SYSTEMOf course, all of the above sounds quite simple and straightforward, but the basicforces of supply and demand are not always allowed to operate freely in the foreign208
Money—Trading the Ultimate Commodity
exchange market. Persians in the 6th century attempted to thwart the basic forcesof supply and demand by fixing an immutable gold/silver ratio. It failed.A more recent attempt to fix prices was made in 1944 when a group of economic and finance experts from 47 Western nations met in a New Hampshire resorttown called Bretton Woods. Their purpose in meeting was to develop a post-warplan for reconstruction of world trade and national economies. Out of that meeting came a plan for an international monetary system. It had four key points:1. The establishment of a super-national agency called the InternationalMonetary Fund whose purpose was to oversee the international monetarysystem and to ensure its smooth functioning.2. The establishment of par values or fixed exchange rates for currenciesand an agreement among the countries that they would manipulate thesupply and demand for their currencies in such a way as to maintain thatrate. They did this by entering the market to buy their currency when itsprice fell 1 percent (in practice, 3/4 of 1 percent) below the declared parand by selling their currency when the price rose 1 percent (in practice,3/4 of 1 percent) above the par value.3. The agreement that the U.S. dollar would be the kingpin of the system andother countries would accept and hold it for payment of international debts.4. The agreement that the U.S. dollar was as good as gold and that any timea foreign government wanted to exchange its dollars for gold it could doso at the U.S. Treasury at the rate of $35 an ounce.This system was in effect from 1944 to 1971, and world trade did indeedexpand during those years. It expanded largely because the U.S. was willing torun its international business affairs at a loss. The U.S. continually imported morethan it exported. It paid for its imports by running the printing presses and printing dollars. As long as others were willing to accept paper dollars, the U.S. receivedfine wines, nice automobiles, radios, televisions, etc., in return.Ultimately, however, there were a lot more dollars held by foreigners than theU.S. held gold. Foreigners had from time to time turned in their dollars for goldand gradually the U.S. gold supply disappeared until clearly the dollar was overvalued in terms of gold.On August 15, 1971, President Nixon declared that the U.S. would no longerabide by the Bretton Woods agreement of 1944. Accordingly, he said that the dollar was no longer convertible into gold; that is, that foreigners would no longer beable to turn their dollars in to the U.S. Treasury and obtain gold. Further, he saidthat the exchange rate for the dollar would no longer be fixed. Instead it would beallowed to “float”; that is, it would be determined by free market forces.The dollar floated just like a rock—straight down. It was devalued. Since thattime, except for a brief period in 1972 when fixed rates were again reinstated, the209
Chapter 21
value of the dollar has been determined more or less by free market forces. Thevalue of groups of other currencies, notably European countries, have been fixed(within a range) in relation to each other, but allowed to float as a group against thedollar. This effort has periodically come apart and required renegotiation.The result of a devaluation of the dollar (or any currency) is that the relativepurchasing power of the U.S. dollar changes, sometimes dramatically. Imports intothe U.S. suddenly cost more (it takes more dollars to buy the same amount of Japaneseyen), and exports from the U.S. are lower priced (fewer yen equal the dollar price).For example, it is not unusual during any year for the value of a bushel of wheat atChicago to increase by 26 percent in U.S. dollars and 40 percent in yen. Thus, itwould take about 14 percent fewer yen to buy the same bushel of U.S. wheat. Putanother way, the same number of yen would buy 14 percent more U.S. wheat.
THE SPOT MARKETThe buying and selling of spot currencies (for immediate delivery or use) is accomplished through banks. Banks all over the world have accounts with each other inorder to serve their customers, many of whom are multinational companies that dealin many different currencies. Every day these banks make deposits and withdrawalsfor their customers. These deposits or withdrawals result in transfers of funds fromone country to another and, therefore, the conversion of one currency into another. Hence, banks worldwide are constantly buying and selling currencies and providing a ready spot market.This buying and selling is done by telephone and teletype. If a dealer inFrankfurt, Germany, wants to buy dollars and sell deutschemarks, he will probablycall several New York banks and ask each for its rate. When he finds a bank witha rate that suits him, the two parties agree to the trade and exchange specially codedtelegrams confirming the transaction. The bank in Frankfurt will then credit theaccount of the New York bank with the proper amount of deutschemarks.If a businessperson desires to covert dollars into deutschemarks to pay a bill,he can simply notify his or her banker and, after receiving proper information, thebanker will see that the proper German bank account is credited. For example, ifa businessperson imports German bicycles and needs deutschemarks to pay forthem, he simply notifies his or her banker who, in turn, contacts other bankers inGermany or elsewhere in the world to buy the deutschemarks for the importer andhave them deposited in the German bank account of the bicycle manufacturer. TheU.S. bank will then deduct the dollar cost of the deutschemarks from the U.S.account of the importer. The importer will never see the deutschemarks; the bankerswill simply debit and credit the appropriate accounts.
210
Money—Trading the Ultimate Commodity
EVALUATING FOREIGN EXCHANGE RATESWhat makes foreign exchange rates fluctuate from day to day? Why did the U.S.dollar buy less in Germany in 1992 than it did in 1986? Would an increase in thegeneral level of interest rates in England be bullish or bearish? For whom?These questions and many more are of great importance to anyone dealingin foreign exchange. And, as you may have guessed, the answers are not easily determined. Fundamental analysis of the money markets is more difficult than fundamental analysis in other commodities. There is often a definite lack of good data,although it is improving, and the markets are highly sensitive to political elements.Yet, over the long run, fundamental economic factors will be the dominant considerations in determining the value of currency. In the short and intermediateterms, technical analysis can be very helpful. Indeed, the currency markets may bebest suited to chart analysis.It is not possible to cover all of the factors in detail here; however, we willtouch on some of the highlights of each of them. For those who would like to digdeeper, there is a considerable amount of literature available at no cost from thefutures exchanges such as the IMM, banks, brokerage houses, etc.
International Trade and Capital BalancesThe single most important long-term indicator of impending exchange rate changestoday is the country’s trade balance, also called the balance of goods and services. It reflects the relative value of merchandise imports and exports.If exports are greater than imports, there is a trade surplus. This is a sign ofcurrency strength. A shift in the trade balance to a deficit (when imports are greaterthan exports), on the other hand, is an indication of currency weakness. Japan’srecent situation is a good example.A second important indicator is the official monetary reserves of a country,including gold, special drawing rights (SDRs) on account at the InternationalMonetary Fund, and foreign currency holdings. These reserves indicate the ability of the country to meet its international obligations; for example, its ability to repayloans, finance imports, and intervene in the foreign exchange market to support(manipulate the value of) its currency. Official reserves should be building upwhen there is a trade surplus. Official reserves may, but not necessarily will, befalling when there is a trade deficit.The third important international economic indicators are the capital balances of a country, including the direct foreign investment and the short-term speculative funds that flow to or from a country. Capital movements are very sensitiveto short-term interest rates.
211
Chapter 21
With the almost instantaneous speed of the world’s financial system, fundsmay be transferred nearly anywhere in the world. These funds move in responseto changes in the relative interest rates. Capital flows can have tremendous impacton short-term exchange rates. If three-month interest rates in Canada increase to1 percent over U.S. rates, people will send their money to Canada. As they do so,they must sell U.S. dollars and buy Canadian dollars. An increase in a country’scapital account reflects an increase in demand for assets denominated in that currency, such as time deposits or Treasury bills. This increased demand indicatesfundamental strength in the currency. Conversely, a deficit in capital accounts indicates a weakening in the demand and an expectation that the price of the currency will fall.
Domestic Economic FactorsThe underlying influences of the balance of trade, official reserves, and capitalflows are the domestic interrelationships between income, prices, and interest rates.Among the factors to consider in evaluating the domestic health of a country are:a. The rate of real (after adjustment for inflation) growth in gross nationalproduct. Steady growth is an overall indicator of good economic health foran economy.b. The rate of growth in money supply and interest rate levels. These areimportant indicators of future economic conditions. The short-term interest rate differential is important in short-term capital flows. Such flowsdirectly affect the demand for a currency.c. The rate of inflation relative to the index of industrial capacity utilization. Differing rates of inflation in different countries are another veryimportant factor affecting the price of a particular currency. The end resultof inflation is an erosion of purchasing power, which ultimately means aweakening of the currency if other countries are not experiencing the sameamount of inflation. High inflation with high utilization suggests thatinflation is likely to stay high because “the machine” is already workingat capacity, yet the people are demanding more goods. This would suggesta weak currency.The general price level of a country affects the exports of that country. TheU.S. is a good example. In the mid-1980s, it had nearly priced itself out of theinternational market in some goods while Japan, on the other hand, making manysimilar goods, was able to sell at lower prices. This reduced the exports of theUnited States and increased the imports to the U.S. from Japan, creating an outflow of dollars and what economists call an “unfavorable” balance of trade. From212
Money—Trading the Ultimate Commodity
1986 to 1992, the dollar fell in value relative to many other currencies, but notproportionately with Japan.Each country should be studied individually and then one country comparedagainst another. Since the IMM futures contracts reflect other currencies relativeto the U.S. dollar, other countries’ expected and actual economic conditions shouldbe compared to the U.S. and to each other. If the conditions seem more favorableto other countries relative to the U.S., sell the futures. If the conditions favor theU.S., buy the contract.
Political and Governmental InfluencesPolitical and governmental activities affect exchange rates by helping or hindering the international trade of a country and thus its balance of trade. Study carefully such things as import taxes, negative interest rates (a favorite of the Swiss,this means you pay them interest on savings accounts instead of the other wayaround), interest equalization taxes, embargoes, etc.The internal political stability of a country also bears on the issue. Even inthe more well-established industrial nations of the world, the unsettling influenceof political elections is reflected in the foreign exchange market. Major economic policy changes, as well as revaluations (up) or devaluations (down), are oftenmade with an eye to the next election. A change in the political party in powervery often brings a change in economic policy. Even the anticipation of a newparty being elected to power can affect exchange rates, which leads us to the significance of expectations or what people think is going to happen.
ExpectationsTiming is all important. Expectations about changes in price level and the timingof such changes can have a great impact on the market. Many observers, for example, expected the British pound to be devalued just before Britain entered theCommon Market. Early in the year, numerous money interests began to act inanticipation of the event, and the British government was forced to float the poundmonths before they would have liked to do so. Similarly, many people expectedthe Mexican peso to be devalued during the latter part of 1982 because a changeof political administration would make it a convenient time to do so. The marketanticipated the event, although not the exact magnitude, long in advance. The pesowas devalued three times by about 90 percent during 1982.
INTEREST RATE ARBITRAGEHow would you like a deal where you borrow money at 10 percent, invest it at 8213
Chapter 21
percent, and make a profit on the deal? Sounds impossible, doesn’t it? It’s not. Infact, it’s done regularly in the foreign exchange market.To demonstrate, let’s suppose your mother-in-law lends you $100,000 inorder to get started on an investment on your own. Let’s say also that your mother-in-law isn’t completely benign, and she charges you a rate of interest that is .5percent over the bank’s prime rate of 9.5 percent. That would be 10 percent (9.5percent plus .5 percent).First you talk to your brother-in-law who suggests you send the money toCanada to be invested in three-month commercial paper (Prime Finance Company)at 8 percent. You suggest that he must be crazy since you’re borrowing at 10 percent. You wanted something conservative but not that conservative! Brother-in-lawsuggests you watch your tongue and let him finish his plan.What he plans is to sell your U.S. $100,000 for spot Canadian dollars, assuming a rate of $.9944. The U.S. $100,000 will provide you with $100,563.15 Canadiandollars. He will then immediately buy an equivalent amount of Canadian commercial paper, due in 90 days, paying for it with the Canadian dollars, returningan annualized rate of 8 percent. You will hold the commercial paper for 90 daysat which time it will mature and be redeemed for Canadian dollars.Now comes the important point. If you wait until the Canadian commercialpaper matures to sell Canadian dollars and obtain U.S. dollars again, your net rateof return may be greater than, less than, or equal to 8 percent, depending on what’shappened to the U.S./Canadian dollar exchange rate. If the Canadian dollar hasincreased in value to, say, $1.0232, a 2.89 percent increase, the net annualized returnon the transactions will be 19.56 percent. If it has decreased in value, the 8 percentwill be reduced accordingly because you’ll be selling the Canadian dollars for lessthan you originally paid for them. If the spot rate hasn’t changed, you’ll reap the 8percent, minus transaction costs, of course, which are usually quite small.Of course, you tell your brother-in-law you don’t want to take the risk thatyour Canadian dollars will change in value during the time of your investment. Yourbrother-in-law explains there is a way to avoid that risk and calculate your exactreturn before you ever buy the Canadian dollars. “How’s that?” you ask. By hedging, he says. By selling a futures contract now, you set the price you will receivefor the Canadian dollars in 90 days and establish, therefore, the exact net rate ofreturn on your investment.He explains that at the present time a three-month futures contract forCanadian dollars is selling at a 2.49 percent annualized premium over the spot. Thus,you can buy the spot Canadian dollars today, immediately resell them for delivery in 90 days on a futures contract, and make a 2.49 percent annualized return onthat transaction. The Canadian dollars you buy today will not be delivered in fulfillment of the futures contract for 90 days, so you invest them in 90-day commercial paper, which yields an 8 percent annual return. The net on all the transactions then turns out to be 10.49 percent.214
Money—Trading the Ultimate Commodity
Now obviously, in the scenario described above, you are not going to getrich very fast, mostly because you’re paying such a high rate of interest to yourmother-in-law. If your mother-in-law were a little less greedy and would give youthe money for a reduced interest rate, you’d obviously be doing better.The procedure just described is referred to by foreign exchange traders asinterest arbitrage. It’s the purchase and sale of spot and futures