Foreign Currency Adjustments

you're saying you want to take a view divergent from the forwards? this is the essence of the yen carry trade.

but no currency is 'undervalued' according to the forwards. like you said the forwards are built off the current spot rate and rate differentials. there is no arb in the mechanism itself....the forward prices are where they are to eliminate any arb.

if the forwards are realized by definition you will make no money.

to make money, you need to take a view divergent from the forwards.

no - don't buy the forwards. buy the actual currency pairs in the hopes that they will tend towards the forwards. I'm saying don't even bother buying/selling/ doing anything with futures contracts other than use them for information. Here's an example.

Futures contract for EURUSD = 1.36480 for December 2007, but the currency pair is currently trading at 1.3548, so not much of a difference, but a little bit. So, say I simply buy Euros in the hopes that they appreciate (as Euros are predicted to do according to interest rate differential, etc. already present in the futures contract price).

Say then in December the actual exch. rate is exactly what the future predicted - that is 1.3648 or a small but positive change of about 1% - you would make this.

I'm just thinking futures rates are probably the best guess of where a currency is going to be at at a given point in time in the future - so why not use them to actually speculate (i.e. not buy them, but the underlying currency).

If you did this with enough currency pairs then idiosyncratic volatility/risk would be minimized and i think you should, on average, make money. Then simply leverage this up. Am I right in thinking this?

Any currency traders in here?

How is the forward price derived?

Well if we take eurodollar at the moment if I sell on euro I get approx 1.36 dollars yes?

So what will the exchange rate be in the future?

Well at t=0 1 EUR = 1.36 USD

So we sell one EUR and buy 1*spot USD, net balance 0

And therefore after one year we have:

We owe 1 EUR * EUR interest rate

and we have 1 * spot USD * USD interest rate

We can say that for there to be no arbitrage the net position must still be zero so:

(1 * spot * USD int rate) / future spot = 1 EUR * EUR int rate

and so future spot = spot * (USD int/EUR int) so the future price is fixed by your initial argument.

Now if you're market making forwards you'll obviously (at least try!) to buy slightly under this and sell slightly above and in this case, assuming u hedge out your interest exposure) you can lock in an instant profit.

The way to think of these is more like this, most currencies are quoted USD/XXX and we can see that the forward points are going to depending on 3 things, the spot, the USD interest rates and XXX interest rates. The spot and the USD rates are known - and USD rates can be seen long into the future and hedged - so we can find an implied interest rate in XXX so we can lend and borrow over different time periods and make money

Does that make sense to you?

So which part of the word exact don't you understand?

oh and because of bid offer spreads you've actually lost money....

why don't you try that strategy (taking into account bid-ask spreads) and tell us your results?

well this post was a disaster - next time i will be much clearer at explaining the strategy. However, I maintain that if you enter into a position that appreciates by say 100 pips, leveraged 10x you clearly make money, trading on your own with say GFT Forex. The only personal currency trading system which charges and gives you interest i know of is oanda. I don't know what BBand is talking about.

Seriously Paul, then get yourself set up with a little bit of cash, try it out and let us know how it works. Also, remember the leverage isn't free.

do you understand how the currency gain offsets the lost interest though?

" maybe i was unclear with the strategy - i was thinking just buy at current prices in the hopes that the exchange rate will tend towards the forward/future strike price. Would this work over a longer term?"

well..seriously now...this could be an investment strategy (you choose as the best estimate of the market what the futures predict) but in NO CASE it is an arbitrage strategy...so the strategy doesnt have any clear advantage over any other one.. The foregone interest that Jimbo mentioned is the first (and best) "theoretical" argument against it...

Now some practical ones that should make sense too: so first point: VERY uncertain if profitable at all even if you diversify a lot (compare it to an index strategy...long or short whatever the futures predict today for some stocks...even if you diversify over a large portfolio it's very uncertain that you win something at all in one year from now...nobody can claim that if you manage a portfolio 1000 stocks you'll get a profit...) second point: what would be your strategy if let's say futures' predictions for 31/12 reversed in 1m from now????rebalance your portfolio?how about the cost of doing that? remember that futures prices change as long as new info comes in....(classic example of a quite volatile contract: Fed Funds futures...) third point (and probably ignored...): suppose you target at least a 6%-7% profit so that your strategy makes sense...you must leverage at least 10x to have hopes to achieve that...now how about if at some point between now and the end of the year the prices moved against you?would you have the capital to cover a possible margin call?

I didn't read it all, but no, the strategy doesn't work. Simple financial engineering tells you so.

For example -- a future on a stock is priced at current price x interest rate. This is enforced by arbitrage. Can you buy the stock, go short the future, and hope that the stock outperforms the risk-free rate? Yup.

But will you get some form of excess return? Nope.

his question was not if this is an arbitrage opportunity...undoubtedly it's not...his question was if this is a good investment strategy at all....