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FORWARD PREMIUM

The forward premium arises due to interest differentials between two currencies. In order that the twocurrencies have the same intrinsic values as they have today and avoid interest arbitrage, the premium/discountcomes into effect. The forward rate includes the forward premium/discount and so the risk of spot marketmoving in the wrong way is minimized by entering into a f

OUTRIGHT FORWARDS

An outright forward transaction, like a spot transaction, is a straightforward single purchase/ sale of onecurrency for another. The only difference is that spot is settled, or delivered, on a value date no later than twobusiness days after the deal date, while outright forward is settled on any pre-agreed date three or more businessdays after the deal date. Dealers use the term outright forward to make clear that it is a single purchase or saleon a future date, and not part of an FX swap.

There is a specific exchange rate for each forward maturity of a currency, almost always different from the spotrate. The exchange rate at which the outright forward transaction is executed is fixed at the outset. No moneynecessarily changes hands until the transaction actually takes place, although dealers may require somecustomers to provide collateral in advance.

Outright forwards can be used for a variety of purposescovering a known future expenditure, hedgingspeculating, or any number of commercial, financial, or investment purposes. The instrument is very flexible,and forward transactions can be tailored and customized to meet the particular needs of a customer with respectto currency, amount, and maturity date. Of course, customized forward contracts for nonstandard dates oramounts are generally more costly and less liquid, and more difficult to reverse or modify in the event of needthan are standard forward contracts. Also, forward contracts for minor currencies and exotic currencies can bemore difficult to arrange and more costly.

Outright forwards in major currencies are available over-the-counter from dealers for standard contract periodsor straight dates (one, two, three, six, and twelve months); dealers tend to deal with each other on straight

dates. However, customers can obtain odd-date or broken-date contracts for deals falling between standarddates, and traders will determine the rates through a process of interpolation. The agreed-upon maturity canrange from a few days to months or even two or three years ahead, although very long-dated forwards are rarebecause they tend to have a large bid-asked spread and are relatively expensive.

Relationship of Forward to SpotCovered

Interest Rate Parity The forward rate for any two currencies is a function of their spot rate and the interest ratedifferential between them. For major currencies, the interest rate differential is determined in the Eurocurrencydeposit market. Under the covered interest rate parity principle, and with the opportunity of arbitrage, theforward rate will tend toward an equilibrium point at which any difference in Eurocurrency interest rates

between the two currencies would be exactly offset, or neutralized, by a premium or discount in the forwardrate.

If, for example, six-month Euro-dollar deposits pay interest of 5 percent per annum, and six-month Euro-yendeposits pay interest of 3 percent per annum, and if there is no premium or discount on the forward yen againstthe forward dollar, there would be an opportunity for round-tripping and an arbitrage profit with no exchangerisk. Thus, it would pay to borrow yen at 3 percent, sell the yen spot for dollars and simultaneously reselldollars forward for yen six months hence, meanwhile investing the dollars at the higher interest rate of 5 percentfor the six-month period

This arbitrage opportunity would tend to drive up the forward exchange rate of the yen relative to the dollar (or

force some other adjustment) until there were an equal return on the two investments after taking into account

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the cost of covering the forward exchange risk. Similarly, if short-term dollar investments and short-term yeninvestments both paid the same interest rate, and if there were a premium on the forward yen against theforward dollar, there would once again be an opportunity for an arbitrage profit with no exchange risk, whichagain would tend to reduce the premium on the forward yen (or force some other adjustment) until there werean equal return on the two investments after covering the cost of the forward exchange risk. In this state ofequilibrium, or condition of covered interest rate parity, an investor (or a borrower) who operates in the forwardexchange market will realize the same domestic return (or pay the same domestic cost) whether investing(borrowing) in his domestic currency or in a foreign currency, net of the costs of forward exchange rate cover.

The forward exchange rate should offset, or neutralize, the interest rate differential between the two currencies.The forward rate in the market can deviate from this theoretical, or impliedderived from the interest rate differential to the extent that there are significantor market inefficiencies that prevent arbitrage from taking place in a timely manner. Such constraints could takethe form of transaction costs, information gaps, government regulations, taxes, unavailability of comparableinvestments (in terms of risk, maturity, amount, etc.), and other impediments or imperfections in the capitalmarkets. However, todays large and deregulated foreign exchange markets and Eurocurrency deposit marketsfor the dollar and other heavily traded currencies are generally free of major impediments.

ROLE OF THE OFFSHORE DEPOSIT MARKETS FOR EURO-DOLLARS AND OTHER

CURRENCIES

Forward contracts have existed in commodity markets for hundreds of years. In the foreign exchange markets,forward contracts have been traded since the nineteenth century, and the concept of interest arbitrage has beenunderstood and described in economic literature for a long time. (Keynes wrote about it and practiced it in the1920s.) But it was the development of the offshore Eurocurrency deposit marketsthe markets for offshoredeposits in dollars and other major currenciesin the 1950s and 60s that facilitated and refined the process ofinterest rate arbitrage in practice and brought it to its present high degree of efficiency, closely linking theforeign exchange market and the money markets of the major nations, and equalizing returns through the twochannels. With large and liquid offshore deposit markets in operation, and with information transfers greatlyimproved and accelerated, it became much easier and quicker to detect any significant deviations from covered

interest rate parity, and to take advantage of any such arbitrage opportunities. From the outset, deposits in theseoffshore markets were generally free of taxes, reserve requirements, and other government restrictions.

The offshore deposit markets in London and elsewhere quickly became very convenient for, and closelyattached to, the foreign exchange market. These offshore Eurocurrency markets for the dollar and other majorcurrencies were, from the outset, handled by the banks foreign exchange trading desks, and many of the samebusiness practices were adopted. These deposits trade over the telephone like foreign exchange, with a bid/offerspread, and they have similar settlement dates and other trading conventions. Many of the same counterpartiesparticipate in both markets, and credit risks are similar.

It is thus no surprise that the interest rates in the offshore deposit market in London came to be used for interest

parity and arbitrage calculations and operations. Dealers keep a very close eye on the interest rates in theLondon market when quoting forward rates for the major currencies in the foreign exchange market. Forcurrencies not traded in the offshore Eurocurrency deposit markets in London and elsewhere, deposits indomestic money markets may provide a channel for arbitraging the forward exchange rate and interest ratedifferentials How Forward Rates are Quoted by Traders Although spot rates are quoted in absolute termssayx yen per dollarforward rates, as a matter of convenience are quoted among dealers in differentialsthat is,in premiums or discounts from the spot rate. The premium or discount is measured in points, which representthe interest rate differential between the two currencies for the period of the forward, converted into foreignexchange.

Specifically, points are the amount of foreign exchange (or basis points) that will neutralize the interest rate

differential between two currencies for the applicable period. Thus, if interest rates are higher for currency A

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than currency B, the points will be the number of basis points to subtract from currency As spot exchange rateto yield a forward exchange rate that neutralizes or offsets the interest rate differential. Most forward contractsare arranged so that, at the outset, the present value of the contract is zero. Traders in the market thus know thatfor any currency pair, if the base currency earns a higher interest rate than the terms currency, the base currencywill trade at a forward discount, or below the spot rate; and if the base currency earns a lower interest rate thanthe terms currency, the base currency will trade at a forward premium, or above the spot rate.

Whichever side of the transaction the trader is on, the trader wont gain (or lose) from both the interest rate

differential and the forward premium/discount. A trader who loses on the interest rate will earn the forwardpremium, and vice versa. Traders have long used rules of thumb and shortcuts for calculating whether to add orsubtract the points. Points are subtracted from the spot rate when the interest rate of the base currency is thehigher one, since the base currency should trade at a forward discount; points are added when the interest rate ofthe base currency is the lower one, since the base currency should trade at a forward premium

Another rule of thumb is that the points must be added when the small number comes first in the quote of thedifferential, but subtracted when the larger number comes first. For example, the spot CHF might be quotedat1.5020- 30, and the 3-month forward at 40-60 (to be added) or 60-40 (to be subtracted). Also, thespread will always grow larger when shifting from the spot quote to the forward quote. Screens now showpositive and negative signs in front of points, making the process easier still.

NON-DELIVERABLE FORWARDS (NDFS)

In recent years, markets have developed for some currencies in non-deliverable forwards. This instrument isin concept similar to an outright forward, except that there is no physical delivery or transfer of the localcurrency. Rather, the agreement calls for settlement of the net amount in dollars or other major transactioncurrency. NDFs can thus be arranged offshore without the need for access to the local currency markets, andthey broaden hedging opportunities against exchange rate risk in some currencies otherwise consideredunhedgeable. Use of NDFs with respect to certain currencies in Asia and elsewhere is growing rapidly.

OPTIONS, FORWARD CONTRACTS, SWAPS AND OTHER DERIVATIVE SECURITIES

THE SIZE OF THE MARKET

The market for derivative securities has become very large in recent years. Worldwide in the 1990's thesesecurities provided "insurance" on an estimated $16 trillion of financial securities. In 2007, according to theInternational Swaps and Derivatives Association the notional value of all financial swaps was $587 trillionworldwide. The gross domestic product of the entire world in 2008 was only about $60 trillion.

The economic function of swaps and derivatives is to transfer risk from those who have it but who do not wantto bear it to those who are willing to bear it for a fee. In this respect the derivatives market is much the same asthe insurance industry. For example, a put option is insurance against the price of a stock falling. And, like the

insurance industry, both the insuree and insurer are better off as a result of the transaction. However, oneusually does not refer to this insurance function as insuring; it is called hedging.

Most of the transactions in these derivative securities is for speculation rather than for hedging. Nevertheless thespeculators serve a purpose. They provide the liquidity for the market to fulfill its social function of transferringrisk. For an example of the size of the market for derivatives compared to the underlying asset consider that thenotional value of the credit default swaps in 2007 was $62.2 trillion. The total value of household real estate atthat time was only $19.9 trillion.

A major part of the financial crisis of 2008 came as a result of businesses with risk involving their investment inhome mortgages finding that that had not really transfered risk. This happened because they dealt with counter

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parties who could not possibly fulfill the financial obligations they had incurred. Thus the businesses with a riskof mortgagee defaults had merely transformed that risk into counter-party risk. However because the businessesthought they had transfered the risk they more heavily invested in the risky securities. Thus when mortgagedefaults began to escalate the businesses found that in fact did not really have default insurance which meanttheir mortgage assets were worth far less than they had thought.

The derivative market, like the insurance industry, does involve gambling. The sizes of the bets in the financialmarkets however are vastly greater than in the gambling industry. Salomon Brothers had in the recent past

derivative contracts for more than $600 billion in securities. The leader in derivative securities has beenChemical Bank which has contracts for $2.5 trillion in securities.

The sizes of the involvement of banks and stock brokerage firms in derivative securities raises fears that therecould be a catastrophic loss that would bring about a collapse of the financial system. There had been caseswhich demonstrate the real dangers of such speculation. A German corporation, Metallgesellschaft, had anAmerican subsidiary, MG Corp., which had been playing the derivative market. MG reported losses in 1993 of$500 million and its total losses could go to $800 million.

On the other hand, some participants in the derivatives markets are reporting huge profits. Chemical Bankreported profits of $236 million for the first nine months of 1993 and J.P. Morgan reported gains of $512

million.

SWAPS

The derivatives market involves more than just put and calls options. There are also contracts involvingswapping fixed interest rate payment streams for adjustable or floating interest rate payment streams. Acompany may have borrowed money under an adjustable interest rate security such as a mortgage and is nowfearful that the interest rate is going to rise. It wants to protect itself against rises in the interest rates withoutgoing through the refinancing of the mortgage. The company or individual liable for an adjustable rate looks forsomeone who will pay the adjustable interest payments in return for receipt of fixed rate payments. This iscalled a swap. The origin of swaps can be identified as a deal made between IBM and the World Bank. For

more on swaps and their history.

OTHER DERIVATIVE SECURITIES

There are many other contracts that businesses may find of interest. A cap is a contract that protects againstrises in the interest rate beyond some limit. Likewise some businesses may want protection against a price dropbeyond some level. This type of contract is called a floor. A swaption (option on a swap) gives the holder theright to enter into or the right to cancel out of a swap. Similarly there are captions and floortions (options oncaps and options on floors).

FORWARD CONTRACTS AND FUTURES

Swaps, caps, and floors are recent innovations in the derivatives markets. The derivatives market traditionallyincluded forward contracts in addition to options (puts, calls, warrants). A forward contract involved acommitment to trade a specified item at a specified price at a future date. For example, if an American companywill have need of 1 million British pounds six months from now they may avoid exposure to exchange rate riskby entering into a forward contract for the pounds now. The forward contract takes whatever form the twoparties agree to. There is also a market for standardized forward contracts, which is called the futures marketThe standardization makes possible a wider market with greater liquidity and efficiency.

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Often the futures markets eliminate the ties between specific parties, the party and the counter-party, and therisk that the other might not fulfill the contract. In the futures market everyone deals with the clearinghouse whoguarantees fulfillment.

OPTIONS

In the options market there has developed some terminology that is somewhat intimidating to the uninitiated. Acall option is the right to buy a share of a stock, the underlying security, at a specified price, called the exercise

price or the strike price. A put option is the right to sell a share of a stock at a specified price, the exercise priceor the strike price.

There is a limited time for the exercise of the call option. An American option can be exercised at any time upto and including the expiration date. A European option can only be exercised on the expiration date. The valueof a call option at any time depends upon:

1. The current market price of the underlying security2. The exercise price3. The interest rate4. Time remaining until expiration

5. The volatility of the price of the underlying security.When any of these change the value of the option will change. The options terminology that is most obscure the use of Greek letters to refer to the response of the option value to changes in the variables which affect it. Delta = the change in the price of the option per unit change in the price of the underlying; i.e., the increase inoption value if the current market price of the stock goes up by one dollar. Delta is important in creating aperfectly hedged portfolio. The rate of change of the delta of an option is called its gamma. Rho = the rate of change in the price of an option in response to a unit change in the interest rate. Theta = the rate of change in the price of an option with respect to time; i.e., the change as the time untilexpiration decreases by one unit.Vega (this is not a Greek letter) = the rate of change in the price of an option for a unit change in volatility.

FUTURES CONTRACT

In finance, a futures contract is a standardized contract between two parties to buy or sell aspecified asset (e.g. oranges, oil, gold) of standardized quantity and quality at a specified futuredate at a price agreed today (the futures price). The contracts are traded on a futures exchange.Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are stillsecurities, however, though they are a type ofderivative contract. The party agreeing to buy theunderlying asset in the future assumes a long position, and the party agreeing to sell the asset inthe future assumes a short position.

The price is determined by the instantaneous equilibrium between the forces of supply and demand amongcompeting buy and sell orders on the exchange at the time of the purchase or sale of the contract. In many casesthe underlying asset to a futures contract may not be traditional "commodities" at all that is, forfinancialfutures, the underlying asset or item can be currencies, securities orfinancial instruments and intangible assetsor referenced items such as stock indexes and interest rates. The future date is called the delivery date orfinalsettlement date. The official price of the futures contract at the end of a day's trading session on the exchange iscalled the settlement price for that day of business on the exchange. A closely related contract is aforwardcontract; they differ in certain respects. Futures contracts are very similar to forward contracts, except they areexchange-traded and defined on standardized assets.

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Unlike forwards, futures typically have interim partial settlements or "true-ups" in margin requirements. Fortypical forwards, the net gain or loss accrued over the life of the contract is realized on the delivery date. Afutures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereasan option grants the buyer the right, but not the obligation, to establish a position previously held by the sellerof the option. In other words, the owner of an options contract may exercise the contract, but both parties of a"futures contract" mustfulfill the contract on the settlement date. The seller delivers the underlying asset to thebuyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained aloss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures

position has to offset his/her position by either selling a long position or buying back (covering) a shorposition, effectively closing out the futures position and its contract obligations. Futures contracts, or simplyfutures, (but not future orfuture contracts) are exchange-traded derivatives. The exchange's clearing house actsas counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism forsettlement.

ORIGIN

Aristotle described the story ofThales, a poor philosopher from Miletus who developed a "financial device,which involves a principle of universal application". Thales used his skill in forecasting and predicted that theolive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements

with local olive press owners to deposit his money with them to guarantee him exclusive use of their olivepresses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in thefuture and no one knew whether the harvest would be plentiful or poor and because the olive press owners werewilling to hedge against the possibility of a poor yield. When the harvest time came, and many presses werewanted concurrently and suddenly, he let them out at any rate he pleased, and made a large quantity of money.

The first futures exchange market was the Djima Rice Exchange in Japan in the 1730s, to meet the needs ofsamurai whobeing paid in rice, and after a series of bad harvestsneeded a stable conversion to coin. TheChicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864which were called futures contracts. This contract was based on grain trading and started a trend that sawcontracts created on a number of different commodities as well as a number of futures exchanges set up in

countries around the world. By 1875 cotton futures were being traded in Mumbai in India and within a fewyears this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.

STANDARDIZATION

Futures contracts ensure theirliquidity by being highly standardized, usually by specifying:

The underlyingasset or instrument. This could be anything from a barrel ofcrude oil to a short terminterest rate.

The type of settlement, either cash settlement or physical settlement. The amountand units of the underlying asset per contract. This can be the notional amount of bonds, a

fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over whichthe short term interest rate is traded, etc.

The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the

case of physical commodities, this specifies not only the quality of the underlying goods but also themanner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifiesthe acceptable sulphur content and API specific gravity, as well as thepricing point-- the location wheredelivery must be made.

The delivery month. The last trading date. Other details such as the commodity tick, the minimum permissible price fluctuation.

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MARGIN

To minimize credit riskto the exchange, traders must post a margin or a performance bond, typically 5%-15%of the contract's value. To minimize counterparty riskto traders, trades executed on regulated futures exchangesare guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to eachbuyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders totransact without performing due diligence on their counterparty. Margin requirements are waived or reduced insome cases forhedgers who have physical ownership of the covered commodity orspread traders who haveoffsetting contracts balancing the position.

Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers'open futures and options contracts. Clearing margins are distinct from customer margins that individual buyersand sellers of futures and options contracts are required to deposit with brokers. Customer margin Within thefutures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers ofoptions contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsiblefor overseeing customer margin accounts. Margins are determined on the basis of market risk and contractvalue. Also referred to as performance bond margin.

Initial margin is the equity required to initiate a futures position. This is a type of performance bond. Themaximum exposure is not limited to the amount of the initial margin, however the initial margin requirement iscalculated based on the maximum estimated change in contract value within a trading day. Initial margin is setby the exchange. If a position involves an exchange-traded product, the amount or percentage of initial marginis set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the brokerwill make a margin call in order to restore the amount of initial margin available. Often referred to as variationmargin, margin called for this reason is usually done on a daily basis, however, in times of high volatility abroker can make a margin call or calls intra-day.

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Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right toclose sufficient positions to meet the amount called by way of margin. After the position is closed-out the clientis liable for any resulting deficit in the clients account. Some U.S. exchanges also use the term maintenancemargin, which in effect defines by how much the value of the initial margin can reduce before a margin call ismade. However, most non-US brokers only use the term initial margin and variation margin.

The Initial Margin requirement is established by the Futures exchange, in contrast to other securities InitialMargin (which is set by the Federal Reserve in the U.S. Markets). A futures account is marked to market daily

If the margin drops below the margin maintenance requirement established by the exchange listing the futures, amargin call will be issued to bring the account back up to the required level.

Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain inhis margin account. Margin-equity ratio is a term used by speculators, representing the amount of their tradingcapital that is being held as margin at any particular time. The low margin requirements of futures results insubstantial leverage of the investment. However, the exchanges require a minimum amount that variesdepending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. Atrader, of course, can set it above that, if he does not want to be subject to margin calls.

Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or

an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment ofequity or down payment on the commodity itself, but rather it is a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain or loss comparedto the exchanges perceived risk as reflected in required margin. ROM may be calculated (realized return) /(initial margin). The Annualized ROM is equal to (ROM+1) (year/trade duration)-1. For example if a trader earns 10%on margin in two months, that would be about 77% annualized.

Settlement - physical versus cash-settled futures

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of

futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the sellerof the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery iscommon with commodities and bonds. In practice, it occurs only on a minority of contracts. Most arecancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale(covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymexcrude futures contract uses this method of settlement upon expiration

Cash settlement- a cash payment is made based on the underlying reference rate, such as a short terminterest rate index such as Euribor, or the closing value of a stock market index. The parties settle bypaying/receiving the loss/gain related to the contract in cash when the contract expires. [8]Cash settled

futures are those that, as a practical matter, could not be settled by delivery of the referenced item - i.e.how would one deliver an index? A futures contract might also opt to settle against an index based ontrade in a related spot market. Ice Brent futures use this method.

Expiry (orExpiration in the U.S.) is the time and the day that a particular delivery month of a futures contractstops trading, as well as the final settlement price for that contract. For many equity index and interest ratefutures contracts (as well as for most equity options), this happens on the third Friday of certain trading months.On this day the t+1 futures contract becomes the tfutures contract. For example, for most CME and CBOTcontracts, at the expiration of the December contract, the March futures become the nearest contract. This is anexciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes)during which the underlying cash price and the futures price sometimes struggle to converge.

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At this moment the futures and the underlying assets are extremely liquid and any disparity between an indexand an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is causedby traders rolling over positions to the next contract or, in the case of equity index futures, purchasingunderlying components of those indexes to hedge against current index positions. On the expiry date, aEuropean equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eightmajor markets almost every half an hour.

PRICING

When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futurescontract is determined via arbitrage arguments. This is typical forstock index futures, treasury bond futures, andfutures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). Howeverwhen the deliverable commodity is not in plentiful supply or when it does not yet exist - for example on cropsbefore the harvest or on EurodollarFutures orFederal funds rate futures (in which the supposed underlyinginstrument is to be created upon the delivery date) - the futures price cannot be fixed by arbitrage. In thisscenario there is only one force setting the price, which is simple supply and demand for the asset in the futureas expressed by supply and demand for the futures contract.

ARBITRAGE ARGUMENTS

Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply, or may befreely created. Here, the forward price represents the expected future value of the underlying discounted at therisk free rateas any deviation from the theoretical price will afford investors a riskless profit opportunity andshould be arbitraged away.

Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found bycompounding the present value S(t) at time tto maturity Tby the rate of risk-free return r. or, with continuouscompoundingThis relationship may be modified for storage costs, dividends, dividend yields, and convenience

yields. In a perfect market the relationship between futures and spot prices depends only on the above variables;in practice there are various market imperfections (transaction costs, differential borrowing and lending rates,restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies withinarbitrage boundaries around the theoretical price.

Pricing via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannotbe applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today'ssupply and demand for the underlying asset in the futures. In a deep and liquid market, supply and demandwould be expected to balance out at a price which represents an unbiased expectation of the future price of the

actual asset and so be given by the simple relationship. By contrast, in a shallow and illiquid market, or in amarket in which large quantities of the deliverable asset have been deliberately withheld from markeparticipants (an illegal action known as cornering the market), the market clearing price for the futures may stillrepresent the balance between supply and demand but the relationship between this price and the expectedfuture price of the asset can break down.

RELATIONSHIP BETWEEN ARBITRAGE ARGUMENTS AND EXPECTATION

The expectation based relationship will also hold in a no-arbitrage setting when we take expectations withrespect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly

prices the deliverable commodity.

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CONTANGO AND BACKWARDATION

The situation where the price of a commodity for future delivery is higher than the spot price, or where a farfuture delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the priceof a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower thana nearer future delivery, is known as backwardation.

FUTURES CONTRACTS AND EXCHANGES

CONTRACTS

There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assetsabout which the contract may be based such as commodities, securities (such as single-stock futures), currenciesor intangibles such as interest rates and indexes. For information on futures markets in specific underlyingcommodity markets, follow the links. For a list of tradable commodities futures contracts, see List of tradedcommodities. See also the futures exchange article.

Foreign exchange market Money market

Bond market Equity market Soft Commodities market

Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly inHolland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets wereestablished and a marketplace was created for farmers to bring their commodities and sell them either forimmediate delivery (also called spot or cash market) or for forward delivery. These forward contracts wereprivate contracts between buyers and sellers and became the forerunner to today's exchange-traded futurescontracts. Although contract trading began with traditional commodities such as grains, meat and livestockexchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity

indexes, government interest rates and private interest rates.

Exchanges

Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME)and these instruments became hugely successful and quickly overtook commodities futures in terms of tradingvolume and global accessibility to the markets. This innovation led to the introduction of many new futuresexchanges worldwide, such as theLondon International Financial Futures Exchangein 1982 (nEuronext.liffe), Deutsche Terminbrse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Todaythere are more than 90 futures and futures options exchanges worldwide trading to include:[9]

CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives (including USBonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (DowJones Industrial Average); Metals (Gold, Silver), Index (NASDAQ, S&P, etc.)

Intercontinental Exchange (ICE Futures Europe) - formerly the International Petroleum Exchange tradesenergy including crude oil, heating oil, natural gas and unleaded gas

NYSE Euronext - which absorbed Euronext into which London International Financial Futures andOptions Exchange orLIFFE (pronounced 'LIFE') was merged. (LIFFE had taken over LondonCommodities Exchange ("LCE") in 1996)- softs: grains and meats. Inactive market in Baltic Exchangeshipping. Index futures include EURIBOR, FTSE 100, CAC 40, AEX index.

South African Futures Exchange - SAFEX Sydney Futures Exchange

Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures)

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Tokyo Commodity Exchange TOCOM Tokyo Financial Exchange - TFX - (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate

Futures) Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures) London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel,tin and steel Intercontinental Exchange (ICE Futures U.S.) - formerly New York Board of Trade - softs: cocoa

coffee, cotton, orange juice, sugar New York Mercantile Exchange CME Group- energy and metals: crude oil, gasoline, heating oil, natura

gas, coal, propane, gold, silver, platinum,copper, aluminum and palladium Dubai Mercantile Exchange Korea Exchange - KRX Singapore Exchange - SGX - into which merged Singapore International Monetary Exchange (SIMEX) ROFEX- Rosario (Argentina) Futures Exchange

Codes

Most Futures contracts codes are four characters. The first two characters identify the contract type, the thirdcharacter identifies the month and the last character is the last digit of the year. Third (month) futures contractcodes are

January = F February = G March = H April = J May = K June = M July = N August = Q September = U October = V

November = X December = Z

Example: CLX0 is a Crude Oil (CL), November (X) 2010 (0) contract.

WHO TRADES FUTURES?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlyingasset (which could include an intangible such as an index or interest rate) and are seeking to hedge outthe riskof price changes; and speculators, who seek to make a profit by predicting market moves and opening aderivative contract related to the asset "on paper", while they have no practical use for or intent to actually take

or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a longfutures or the opposite effect via a short futures contract. Hedgers typically include producers and consumers ofa commodity or the owner of an asset or assets subject to certain influences such as an interest rate.

For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestockthey produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers oftenpurchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial)markets, "producers" ofinterest rate swaps orequity derivative products will use financial futures or equityindex futures to reduce or remove the risk on the swap.xAn example that has both hedge and speculativenotions involves a mutual fund orseparately managed account whose investment objective is to track theperformance of a stock index such as the S&P 500 stock index.

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The Portfolio manageroften "equitizes" cash inflows in an easy and cost effective manner by investing in(opening long) S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistentwith the fund or account investment objective without having to buy an appropriate proportion of each of theindividual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of thepercent of assets invested in the market and helps reduce tracking errorin the performance of the fund/accountWhen it is economically feasible (an efficient amount of shares of every individual position within the fund oraccount can be purchased), the portfolio manager can close the contract and make purchases of each individualstock. The social utility of futures markets is considered to be mainly in the transfer ofrisk, and increased

liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.

OPTIONS ON FUTURES

In many cases, optionsare traded on futures, sometimes called simply "futures options". A put is the option tosell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is thespecified futures price at which the future is traded if the option is exercised. See the Black-Scholes modelwhich is the most popular method for pricing these option contracts. Futures are often used since they are deltaone instruments.

FUTURES CONTRACT REGULATIONS

All futures transactions in the United States are regulated by the Commodity Futures Trading Commission(CFTC), an independent agency of the United States government. The Commission has the right to hand outfines and other punishments for an individual or company who breaks any rules. Although by law thecommission regulates all transactions, each exchange can have its own rule, and under contract can finecompanies for different things or extend the fine that the CFTC hands out.

The CFTC publishes weekly reports containing details of the open interest of market participants for eachmarket-segment that has more than 20 participants. These reports are released every Friday (including data fromthe previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest aswell as commercial and non-commercial open interest. This type of report is referred to as the 'Commitments of

Traders Report', COT-Report or simply COTR.

DEFINITION OF FUTURES CONTRACT

Following Bjrk we give a definition of a futures contract. We describe a futures contract with delivery of itemJ at the time T:

There exists in the market a quoted price F(t,T), which is known as the futures price at time t fordelivery of J at time T.

At time T, the holder pays F(T,T) and is entitled to receive J.

During any time interval (s,t], the holder receives the amount F(t,T) F(s,T).

The spot price of obtaining the futures contract is equal to zero, for all time tsuch that t< T.

NONCONVERGENCE

Some exchanges tolerate 'Nonconvergence', the failure of futures contracts and the value of the physicacommodities they represent to reach the same value on 'contract settlement' day at the designated deliverypoints. An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures.

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SRW futures have settled more than 20 apart on settlement day and as much as $1.00 difference betweensettlement days. Only a few participants holding CBOT SRW futures contracts are qualified by the CBOT tomake or receive delivery of commodities to settle futures contracts. Therefore, it's impossible for almost anyindividual producer to 'hedge' efficiently when relying on the final settlement of a futures contract for SRWThe trend is for the CBOT to continue to restrict those entities that can actually participate in settlingcommodities contracts to those that can ship or receive large quantities of railroad cars and multiple barges at a

few selected sites. The Commodity Futures Trading Commission, which has oversight of the futures market inthe United States, has made no comment as to why this trend is allowed to continue since economic theory andCBOT publications maintain that convergence of contracts with the price of the underlying commodity theyrepresent is the basis of integrity for a futures market. It follows that the function of 'price discovery', the abilityof the markets to discern the appropriate value of a commodity reflecting current conditions, is degraded inrelation to the discrepancy in price and the inability of producers to enforce contracts with the commodities theyrepresent.

FUTURES VERSUS FORWARDS

While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price

they are different in two main respects:

Futures are exchange-traded, while forwards are traded over-the-counter.

Thus futures are standardized and face an exchange, while forwards are customized and face a non-

exchange counterparty.

Futures are margined, while forwards are not.

Thus futures have significantly less credit risk, and have different funding.

EXCHANGE VERSUS OTC

Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be asigned contract between two parties.

THUS:

Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter.

In the case of physical delivery, the forward contract specifies to whom to make the delivery. Thecounterparty for delivery on a futures contract is chosen by the clearing house.

MARGINING

Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price andunderlying asset (based on mark to market). Forwards do not have a standard. They may transact only on thesettlement date. More typical would be for the parties to agree to true up, for example, every quarter. The factthat forwards are not margined daily means that, due to movements in the price of the underlying asset, a largedifferential can build up between the forward's delivery price and the settlement price, and in any event, anunrealized gain (loss) can build up.

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Again, this differs from futures which get 'trued-up' typically daily by a comparison of the market value of thefuture to the collateral securing the contract to keep it in line with the brokerage margin requirements. This true-up occurs by the "loss" party providing additional collateral; so if the buyer of the contract incurs a drop invalue, the shortfall or variation margin would typically be shored up by the investor wiring or depositingadditional cash in the brokerage account. In a forward though, the spread in exchange rates is not trued upregularly but, rather, it builds up as unrealized gain (loss) depending on which side of the trade being discussed.

This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically

occurs, the time the contract is closed prior to expiration) - assuming the parties must transact at the underlyingcurrency's spot price to facilitate receipt/delivery. The result is that forwards have highercredit riskthan futuresand that funding is charged differently. In most cases involving institutional investors, the daily variationmargin settlement guidelines for futures call for actual money movement only above some insignificant amountto avoid wiring back and forth small sums of cash. The threshold amount for daily futures variation margin forinstitutional investors is often $1,000.

The situation for forwards, however, where no daily true-up takes place in turn creates credit riskfor forwardsbut not so much for futures. Simply put, the risk of a forward contract is that the supplier will be unable todeliver the referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date atwhich the opening party closes the contract. The margining of futures eliminates much of this credit risk by

forcing the holders to update daily to the price of an equivalent forward purchased that day. This means thatthere will usually be very little additional money due on the final day to settle the futures contract: only the finalday's gain or loss, not the gain or loss over the life of the contract. In addition, the daily futures-settlementfailure risk is borne by an exchange, rather than an individual party, further limiting credit risk in futures.

Example: Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90.This means that the "mark-to-market" calculation would require the holder of one side of the future to pay $2 onday 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts,to the holder of the other side of the future. That is, the loss party wires cash to the other party.

A forward-holder, however, may pay nothing until settlement on the final day, potentially building up a largebalance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny effects ofconvexity bias (due to earning or paying interest on margin), futures and forwards with equal delivery pricesresult in the same total loss or gain, but holders of futures experience that loss/gain in daily increments whichtrack the forward's daily price changes, while the forward's spot price converges to the settlement price. Thus,while undermark to market accounting, for both assets the gain or loss accrues over the holding period; for afutures this gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized untiexpiry. Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a Europeanderivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, butalso on the path of prices on the way. This difference is generally quite small though. With an exchange-tradedfuture, the clearing house interposes itself on every trade. Thus there is no risk of counterparty default. The only

risk is that the clearing house defaults (e.g. become bankrupt), which is considered very unlikely.

DIFFERENCES BETWEEN A FUTURES CONTRACT AND A FORWARD C

Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to

buy or sell a specific type of asset at a specific time at a given price. However, it is in the specific details th

these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized

contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid

in their stated terms and conditions.

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Because forward contracts are private agreements, there is always a chance that a party may default on its side

of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically

lowers the probability of default to almost never. Secondly, the specific details concerning settlement an

delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract.

Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the

end of the contract.

Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the otherhand, only possess one settlement date. Lastly, because futures contracts are quite frequently employed by

speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to

maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers

that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually

take place.

FORECASTING FOREIGN EXCHANGE RATES

INTRODUCTION

Foreign exchange rate forecasting has become increasingly important since the dissolution of the BrettonWoods system and the advent of floating exchange rates in 1973. The substantial increase in exchange ratevolatility has concomitantly placed a priority on the managerial function of foreign exchange risk management.

Exchange rate forecasts are used by multinational corporations in many important areasmanagement. For example, managers use foreign exchange forecasts to convert future foreign cash flows intodomestic currency units; foreign and domestic costs of capital (or returns on investment) can then be comparedwhen making a foreign financing or investment decision. Likewise, forecasts are required for deciding whetheror not a foreign currency exposure should be hedged or to what extent the exposure needs to be hedged.Monthly projections of foreign subsidiaries' expenses and revenues, which are included in annual budgets, also

require foreign exchange rate forecasts. Furthermore, when formulating long-range strategic plans such as asubsidiary's asset and liability structure, pricing policy, or product mix, foreign exchange rate forecasts areagain needed.

CURRENTLY USED FOREIGN EXCHANGE FORECASTING METHODS

The foreign exchange rate forecasting methods in use today by both commercial services and corporateforecasting departments are primarily econometric, judgmental, or technical methods, as summarized by Levich(1983). The forward rate, which is considered an unbiased predictor of the future spot rate by some scholars(Kohlhagen 1979 and Levich 1979), may also be used to forecast foreign exchange rates in lieu of eitherpurchasing a commercial forecast or incurring the expense of forecasting in-house. The forward rate is the rate

of exchange at which any may contract to buy or sell a foreign currency at a designated future date. As such,forward rates can be used as forecasts of future spot exchange rates. Forward contracts may be of differenmaturities; the more common ones are one-month, three-month, six-month, and one-year contracts.

Econometric methods usually employ a single multiple regression equation. The independent variables areeconomic in nature while the dependent variable is the foreign exchange rate to be forecasted. The specificationof independent variables may be prompted by various economic theories such as purchasing power parity,monetary theory, portfolio balance theory, or the asset approach (Levich 1982). Single-equation models areoften an oversimplification of the real world and, for this reason, some econometric models are comprised ofsystems of equations.

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PURCHASING POWER PARITY

Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative pricelevels of two countries. The idea originated with the School of Salamanca in the 16th century and wasdeveloped in its modern form by Gustav Cassel in 1918. The concept is founded on the law of one price; theidea that in absence of transaction costs, identical goods will have the same price in different markets. In its"absolute" version, the purchasing power of different currencies is equalized for a given basket of goods. In the

"relative" version, the difference in the rate of change in prices at home and abroadthe difference in theinflation ratesis equal to the percentage depreciation or appreciation of the exchange rate.

Deviations from the theory imply differences in purchasing power of a "basket of goods" across countries,which means that for the purposes of many international comparisons, countries' GDPs or other national incomestatistics need to be "PPP adjusted" and converted into common units. The best-known and most-usedpurchasing power adjustment is the GearyKhamis dollar(the "international dollar").Real exchange ratefluctuations are mostly due to different rates of inflation between the two economies. Aside from this volatility,consistent deviations of the market and purchasing power adjusted exchange rates can be observed, for example(market exchange rate) prices of non-traded goods and services are usually lowerin countries with lowerincomes (a U.S. dollarexchanged and spent in India will buy more haircuts than a dollar spent in the United

States).

There can be marked differences between purchasing power adjusted incomes and those converted via marketexchange rates For example, the World Bank'sWorld Development Indicators 2005 estimated that in 2003, oneGeary-Khamis dollarwas equivalent to about 1.8 Chinese yuan by purchasing power parityconsiderablydifferent from the nominal exchange rate. This discrepancy has large implications; for instance, when convertedvia the nominal exchange rates GDP per capita in India is about US$1,100 while on a PPP basis it is aboutUS$3,000. This means that if calculated at nominal exchange rates, India has the eleventh largest economy,while at PPP-adjusted rates; it has the fourth largest economy in the world. At the other extreme, Denmark'snominal GDP per capita is around US$62,100, but its PPP figure is only US$37,304.

PPP MEASUREMENT

The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets ofgoods to compare purchasing power across countries. Estimation of purchasing power parity is complicated bythe fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may begreater than the difference in housing prices, while also less than the difference in entertainment prices. Peoplein different countries typically consume different baskets of goods. It is necessary to compare the cost ofbaskets of goods and services using a price index. This is a difficult task because purchasing patterns and eventhe goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differencesin the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when(as is usually the case) more than two countries are to be compared. When PPP comparisons are to be made

over some interval of time, proper account needs to be made ofinflationary effects.

BIG MAC INDEX

An example of one measure oflaw of one price, which underlies purchasing power parity, is the Big Mac Indexpopularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants indifferent countries. The Big Mac Index is presumably useful because it is based on a well-known good whosefinal price, easily tracked in many countries, includes input costs from a wide range of sectors in the localeconomy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar)advertising, rent and real estate costs, transportation, etc.

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However, in some emerging economies, western fast food represents an expensive niche product price wellabove the price of traditional staplesi.e. the Big Mac is not a mainstream 'cheap' meal as it is in the west but aluxury import for the middle classes and foreigners.

NEED FOR PPP ADJUSTMENTS TO GDP

The exchange rate reflects transaction values fortraded goodsbetween countries in contrast to non-tradedgoods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade

in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Alsodifferent interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The PennWorld Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such asystematic bias in using exchange rates to outputs among countries.

For example, if the value of the Mexican peso falls by half compared to the U.S. dollar, the Mexican GrossDomestic Product measured in dollars will also halve. However, this exchange rate results from internationatrade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes andprices measured in pesos stay the same, they will be no worse off assuming that imported goods are notessential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates

helps to avoid this problem.

PPP exchange rates are especially useful when official exchange rates are artificially manipulated bygovernments. Countries with strong government control of the economy sometimes enforce official exchangerates that make their own currency artificially strong. By contrast, the currency's black market exchange rate isartificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.

DIFFICULTIES

The main reasons why different measures do not perfectly reflect standards of living are

PPP numbers can vary with the specific basket of goods used, making it a rough estimate. Differences in quality of goods are hard to measure and thereby reflect in PPP.

PPP calculations are often used to measure poverty rates.

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:

1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically.

2. Tradable goods such as non-perishable commodities that can be sold on the international market (e.g. diamonds).

The more a product falls into category 1 the further its price will be from the currency exchange rate. (Movingtowards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchangerate. (For more details of why, see: Penn effect). More processed and expensive products are likely to betradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchangerate. Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rateit won't buy three times as much of internationally traded goods like steel, cars and microchips, but non-tradedgoods like housing, services ("haircuts"), and domestically produced crops. The relative price differentiabetween tradable and non-tradable from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in lowincome countries (like Ethiopia), as against high income countries (like Switzerland).