Without financial futures, investors would have only one trading location to alter portfolio positions when they get new information that is expected to influence the value of assets—the cash market. If economic news that is expected to impact the value of an asset adversely is received, investors can reduce their price risk exposure to that asset. The opposite is true if the new information is expected to impact the value of that asset favorably: an investor would increase price-risk exposure to that asset. There are, of course, transaction costs associated with altering exposure to an asset—explicit costs (commissions), and hidden or execution costs (bid-ask spreads and market impact costs).
Futures provide another market that investors can use to alter their risk exposure to an asset when new information is acquired. An investor will transact in the market that is the more efficient to use in order to achieve the objective. The factors to consider are liquidity, transaction costs, taxes, and leverage advantages of the futures contract. The market that investors feel is the one that is more efficient to use to achieve their investment objective should be the one where prices will be established that reflect the new economic information. That is, this will be the market where price discovery takes place. Price information is then transmitted to the other market. It is in the futures market that it is easier and less costly to alter a portfolio position. Therefore, it is the futures market that will be the market of choice and will serve as the price discovery market. It is in the futures market that investors send a collective message about how any new information is expected to impact the cash market.
How is this message sent to the cash market? We know that the futures price and the cash market price are tied together by the cost of carry. If the futures price deviates from the cash market price by more than the cost of carry, arbitrageurs (in attempting to obtain arbitrage profits) would pursue a strategy to bring them back into line. Arbitrage brings the cash market price into line with the futures price. It is this mechanism that assures that the cash market price will reflect the information that has been collected in the futures market.
November 26th, 2010
The unbiased forward rate theory suggests the expected spot exchange rate is the forward rate. If this worked, it would mean that failing to hedge currency risk would yield similar results in the long run to hedging. There are two problems with this. First, the Treasurer would probably be fired before the “long run” arrived. Second, the unbiased forward rate theory is a poor predictor of future exchange rates in practice. Basically it does not work. Therefore, a corporation should use market-based currency forecasting in addition to the forward rate to predict future exchange rates. The discretionary aspect to the currency forecast means the corporation has the choice of hedging:
Tactically and selectively
Strategically
Passively
Corporations vary in their attitude towards transaction hedging. Some hedge passively, that is to say they maintain the same hedging structure and execute over regular periods during the financial year. This type of transaction hedging does not involve the corporation “taking a (currency) view”. The other two types of hedging strategy do indeed involve taking a currency view. Strategic hedging involves the corporation taking a view for a longer period than immediate transaction receivables and payables might require. In January 1999, I remember wave after wave of European corporations hedging both developed and emerging market currency risk as far out as one year. Corporations who usually called in USD20–30 million to hedge very short-term receivables were calling for prices in a number of emerging market currency pairs in USD200–300 million. The Russian crisis of August 1998 and the collapse of LTCM had clearly scared global financial markets. With the threat looming of devaluation in Brazil (which indeed happened in January 1999), many European corporations were apparently taking advantage of the relaxation in global market tensions and reduced risk premiums in the market in the wake of the Fed’s extraordinary monetary easing of August and September, with three interest rate cuts in quick succession to hedge their transactional currency risk as far out as they could go. That is an example of strategic hedging. Finally, tactical and selective hedging of transactional currency risk is the usual business that a corporate dealing desk does with its clients. A bank’s clients may choose to allow certain currency exposures to be translated at the period end, and others they may choose to hedge, depending crucially on their currency view. Typically, it makes sense for a corporation to use the tactical and selective approach for most transactional currency risks and only occasionally to pull the trigger on strategic hedging should the need arise. While passive hedging may appeal to some, it hurts flexibility, not only with regard to the hedging strategy but also with regard to domestic pricing.
July 2nd, 2009