The economy is chock full of natural forward positions. An American company orders a Swiss machine for delivery in three months, payable in Swiss Francs. This order involves a natural forward exchange position, the ultimate value of which depends on the spot exchange rate between dollars and Swiss Francs three months from now.
The same company plans to finance its purchase by issuing dollar-denominated 90-day commercial paper three months from now. This plan involves a natural forward interest-rate position, the ultimate value of which depends on the spot rate of interest three months from now. If over the course of the next three months the exchange value of the dollar falls or the spot rate of interest rises, the company will lose on its natural forward positions, possibly so much so that the planned purchase no longer seems a wise business decision.
To avoid such potential losses, the company would like to hedge its natural forward positions. Ideally, it would like to find a counterparty that has exactly the opposite forward positions, which is to say a company with natural forward positions that will lose value if the exchange value of the dollar rises or the spot rate of interest falls. The coincidence, however, is unlikely.
The ideal counterparty must be expecting to receive Swiss Francs and planning to invest those Francs in a 90-day dollar-denominated instrument, and it must also be planning to make those transactions on exactly the same date and at exactly the same scale. Even if such a company were to exist, and even were the inevitable counterparty risk to prove tolerable, the cost of finding the company and then arranging a one-off bilateral deal is likely prohibitive.
Historically, the banking system arose to solve problems like this. For a fee, a bank sells Swiss Francs forward to the American company and so eliminates the exchange-rate risk. For another fee, it arranges a loan commitment that locks in the interest rate the company will pay. Now the company’s natural forward positions have become the bank’s formal forward contracts, and the company’s problem of finding an ideal counterparty has become the bank’s problem, but with some important differences. First, the bank has numerous clients with diverse payment needs, and some of those payment needs may offset, which means that the very same forward positions may pose less risk to the bank than they do to the company. More important, by dividing the company’s natural forward positions into two separate forward contracts, the bank can search for separate counterparties for each, perhaps even multiple counterparties for each contract.
Contents
1 Introduction
2 Patterns of cash flows
- 2.1 Interest-rate forwards and futures
2.2 Foreign-exchange forwards and futures
3 Data
- 3.1 Interest and exchange rates
3.2 Interest-rate futures
3.3 FX Futures
4 Measurement
- 4.1 Liquidity premium: interest rates
4.2 Liquidity premium: foreign exchange
5 EH and UIP interpretation
6 Time varying risk premia
- 6.1 Verification of the failure of EH
6.2 EH regression with liquidity-risk premium
6.3 Verification of the failure of UIP
6.4 UIP regression with liquidity-risk premium
6.5 Observations
7 Conclusion
