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THE FUTURES MARKET ECONOMIST

**Knowledge emerges from the interaction of individual minds**

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The Futures Market Economist (TFME) is the electronic publication of the ongoing seminar in futures market economics. This seminar is a free voluntary association of individuals interested in the application of economic science towards an understanding of futures and futures options markets.

This seminar is presented biweekly by posting on every other Monday to the following USENET newsgroups:

misc.invest.futures
misc.invest.technical
sci.econ

This seminar is organized and directed by Vern Lyon, Ph.D. His e-mail address is

tfme@pobox.com

BACK ISSUES: The current and back issues of TFME can be obtained at TFME's home page at the following URL:

http://www.aros.net/~vlyon/

DISCLAIMER: This electronic seminar is for educational purposes only. Any use of information obtained from this seminar is not the responsibility of Vern Lyon, Ph.D. Use it strictly at your own risk.

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Volume 3, Number 6, March 30, 1998

Contents

Synthetic Banking Redux
Some Thoughts on "The" Yield Curve

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NOTICE:

TFME is going on vacation for the next 6 weeks to two months. Enjoy!

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Synthetic Banking Redux

I have continued to monitor the synthetic banking operations I have used to illustrate various principles of synthetic banking.

Two of these operations I have followed since June 12, 1997. Another one I started to follow beginning November 10, 1997. In addition I started following another one in December of 1997 and went back to November 2, 1997 for the data on price.

The first operation was to take a long position in a US Treasury bond future and to go short a Japanese Yen futures contract. This operation has performed for better than expected. As of March 20, 1998, a period of 281 days this operation has a yield on $10,000 margin of 371 percent annualized.

The second operation consists of being long 7 Mexican Peso futures contracts and to be short 4 Japanese Yen futures contracts. As of March 20, also a period of 281 days this operation has a yield of 237 percent annualized on $50,000 margin.

However, as I have indicated previously I don't think $50,000 is adequate margin for this position, even though, as it was, it would have been more than adequate. Nevertheless, for benchmark reasons I have stuck with $50,000. It would still be a marvelous yield of 119 percent annualized on $100,000.

The third operation I have followed is to be long 4 British Pound futures contracts and short 4 Japanese Yen futures contracts. At the time I started following this operation I was worried about the peso because of the reverberations from Asia and the fact that the Mexican Bolsa had such a good run that I doubted it was sustainable, and as a result of lot of the Yankee money that had been attracted to the Mexican stock market would return home and in the process hurt the peso. (It did weaken some in December and January, but has stabilized, at least for now.) I might add sterling weakened significantly during this time and with the benefit of hindsight I should not have worried about the peso. Nevertheless as of March 20, 1998, a period of 130 days the long 4 British pound short 4 Japanese yen operation yield 135 annualized percent on $50,000, which I believe is adequate for this position.

Since all of these operations shared having short positions in the yen, which except for January added greatly to the profit of the operations, I decided to follow a different operation that was also relatively low risk. I chose one consisting of being long the D-mark and short the Swiss franc.

It is low risk because of the simple fact that both the D-mark and the Swiss franc are both continental European currencies, and, even more significant, the two countries are subject to many of the same general economic forces. In contrast there are significant differences between the economic forces the affect Japan and Mexico that results in Japan's and Mexico's currencies having less of a tendency to move together.

Because of this the D-mark Swiss franc synthetic banking operation is more of a "pure" interest rate play than are the British pound Japanese yen or the Mexican peso Japanese yen synthetic banking operation.

The results for the D-mark Swiss franc operation, which I arbitrarily chose the first trading day in November, 1997 to begin following, is a return of 184 percent annualized over 137 days on $3000 margin, which seems to be adequate.

These results are all in excess of what can be expected due to the interest rate differentials under the assumption that the current spot prices of the currencies are unbiased estimators of the futures spot prices.

It is interesting to note here that we are assuming that the spot markets in foreign currencies are efficient, in the efficient market sense, but that the forward (futures) markets in foreign currency are NOT efficient. The reason for this is that when there exist interest rate differentials that covered interest arbitrage drives the forward (futures) prices to a discount or premium to the spot price.

Relevant market data for March 20, 1998 for the above four synthetic banking operations are as follows:

In the above table the column "Implied Price" is the value derived from the covered interest parity relationship. These values are close to the actual market values, which is usually the case, a covered interest arbitrageurs are quick to act when the futures price deviates from its covered interest parity price. In the row for the US bond I took the soon to expire March futures price to represent the spot price. In this same row the interest rate is the US short term rate, not the yield on the bond.

Given the market data of March 20, 1998 the following table gives the expected rates of return on the four synthetic banking operations. Also shown is the margin required of the exchanges to take the indicated positions.

These are all attractive yields if the risk is not too high. I have not done enough research on how risky these operations are to say anything definitive, but a place to start is to compare the volatility of synthetic banking operation with the volatility of the S&P 500 stock index. For a very small sample I did this some time in the past with a British pound/Japanese Yen position and found the volatility to be roughly the same. However, much more work on this the riskiness of these operations needs to be done.

Remark:

The data for the four above discussed synthetic banking operations are available on spreadsheets (wk1) in syn_bnk.ZIP, which is available at my website site
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Some Thoughts on "The" Yield Curve

I. Introduction

Futures exchanges rightly claim that their function is to provide price information and risk transfer services for interested individuals or firms. In this essay I will be primarily concerned with the price discovery function; however, since the risk transfer function has effects on price these two functions are not independent. Because of this some discussion of risk transfer and it price effect, risk premiums, will be included.

Futures exchanges facilitate these functions by providing a free exchange environment. Almost anyone can participate in this market, even though public participation must be through a member firm, but the fees are reasonable enough that futures markets, perhaps more than any other markets, are what economists refer to a "competitive markets." Being highly competitive means that it is difficult to consistently make above average profits, where some argue that because of transactions cost average profits in futures markets are less than zero. Nevertheless some individuals excel in competitive environments, and a possible way to approach this competitive arena is to search for those situations where there are imperfections of one sort or another.

In pursuing this line of attack an interesting question to ask is to question how well futures markets perform, for instance, their role of discovering price. If they discovered price instantaneously and exactly then there would be no incentive to engage in many of the techniques that traders use to take a living out of the market. For example, there are many temporary price distortions that enable on the spot traders to profit. It is useful to distinguish this distortions as caused by either natural of man-made forces. The reason for this is that if there are indeed national forces causing what appear to be distortions in the price the market discovers, then the opportunities these "distortions" bring will always be there. On the other hand, the inevitable movement to electronic trading is going to force a considerable change of style on many pit traders who has relied on various market imperfections that are eliminated by electronic trading. How well some pit traders will survive survive in the coming electronic age of trading is an interesting question. My guess is that not many of them will. More importantly, electronic trading will facilitate the the integration of the world economy, which is a significant fact bearing on the subject matter of this essay.

Given that the future price of anything is uncertain the notion that the futures market discovers an accurate price amounts the saying the market is "efficient," or once again the notion of the efficient market hypothesis confronts us. However, as my discussion in the above essay and many essays over the past several months on synthetic banking have discussed the futures market in foreign currencies are not efficient. Furthermore, this finding is supported by a large proportion of (financially disinterested?) academic economists at leading universities that study foreign exchange markets using sophisticated and rigorous techniques. In other words this is not the claim of someone trying to sell you a get rich scheme.

Does this mean that the Chicago Mercantile Exchange's markets in foreign currency futures are doing a bad job of price discovery? Not at all. In the above essay I included the price derived from considerations of covered interest arbitrage for comparison with the settlement prices on some CME currency contracts where it can be observed that the "error" is very small. Instead the "bias" in the futures prices is due to a difference between the interest rates in the foreign and domestic countries. Furthermore the bias is predictable in that if the foreign interest rate exceeds the domestic rate the futures price will be negatively biased, when the foreign interest rate is less than the domestic rate, the futures price will be positively biased, and only when the interest rate are identical will the bias be zero.

This is all a review of topics previously discussed under synthetic banking. However, to understand the synthetic banking operation consisting of being long a US bond future and short a Japanese yen futures depends on some notions associated with what is called "the term structure of interest rates." or the "yield curve." This is because this synthetic banking operation can be considered a yield curve play with a foreign exchange twist. Therefore, I will turn in the next section to discusses some notions related to yield curves. After this section I will conclude with some general comments.

II. The Term Structure of Interest Rate

In an interesting article by University of California, Berkeley economist Jeffrey Frankel, "The Power of the Yield Curve to Predict Interest Rates (or Lack Thereof), " included in his book, Financial Markets and Monetary Policy (1995) makes the case that many others have also made that the yield curve does not represent a situation where prices (interest rates in this case) are efficient.

The conventional view is that if the yield curve is positively sloped that the "market" is telling us that interest rates are headed up. On the other hand when the slope is negative, or there is what is called an "inverted yield curve." then interest rates are headed down. Arbitrage arguments are applied by equating the investment in short-term instruments seriatim with the investment in a long-term instrument. (I leave the details to anyone interested to find in any textbook on financial markets.) Unfortunately for the yield curve theorists, but possibly fortunate for the trader, this theory had been empirically refuted time and again, just like the assumption the foreign exchange futures prices are efficient.

The failure of efficiency in this case according to Frankel "... is of great interest, because the theory's failure would seem to offer traders and investors a valuable opportunity to make money in the financial markets."

In attempting to explain this situation Frankel considers various imperfections. The one he spends the most time on is an "imperfection" due to the existence of risk premiums that can induce a bias in a price or interest rate.

It has often been argued that the rates on long term bonds must exceed the rates on shorter term maturities because the risk of loss is greater on long term bonds. This means the yield curve could be upward sloping even if individuals did not expect interest rates to increase.

Several years ago I was seriously doing research in risk premium theory and found Frankel to be about the only economist to have anything new to say about risk premiums in the last 20 or so years. Because of this I was drawn to his paper on the yield curve to see what he had to say.

Interestingly, Frankel with his sophisticated knowledge of risk premium theory is left dissatisfied that the bias in the yield curve can be explained as an effect of risk premiums. This could mean that the search for the cause of the bias must look elsewhere.

Frankel, unknowingly, provides a hint of where to look. In his paper he reports that over the years 1990-1993 that "the US yield curve had a relatively steep upward slope," while over the same period "the German yield curve was relatively flat; indeed, over the period 1990-93, the term structure was often inverted."

The steep upward slope to the US yield curve was attributed to the Fed's attempt to revive a stalled US economy by providing low interest rates, while the opposite situation in Germany was attributed to a tight monetary policy by the Bundesbank in response to the integration of East and West Germany.

Interesting perhaps, but even more interesting is that it should serve as a red flag to any economist telling her or him that the WORLD ECONOMY IS NOT INTEGRATED, for in a truly integrated world economy under voluntary exchange there can only be ONE yield curve. This means there are enormous arbitrage opportunities, and that they will persist to some degree or another until the economies of the world are truly integrated.

This deviation from what would occur in a competitive world economy expresses the fact that central banks have the power to establish what they want in terms of interest rates and not what the free exchange system would bring about. Of course there are other impediments to a competitive world market, but none as significant by themselves as the fact that central banks have great power.

III. Conclusion

There is much more than can be discussed with respect to yield curves, risk premiums, and central bank intervention. However, at this time I only wish to basically question the notion of "the" yield curve in a world where over $ 1 billion dollars is transacted every day in the foreign exchange markets.

In an essay in TFME The Fed Funds Market and Differential Interest Rates I discussed how when the Federal Reserve System was brought into being that regional Reserve banks had in effect the right to pursue independent monetary policy. An effect of this was that the discount rate would at times between different Reserve banks. Member banks were quick to use the Fed Funds market as a mechanism to arbitrage these interest rate differentials. The Board of Governors of the Fed soon realized that because of this they were in effect "giving" away money to the member banks. This resulted in the Board of Governors establishing a uniform discount rate to prevent this gift to the member banks. This was before the Keynesian episode in economic thought rationalized many of the financial practices in effect today. It is now considered the proper role of government by Keynesian-Capitalists for the government to give a subsidy every time it buys or sells anything from toilet seats to government securities.

It is interesting that in Japan Keynesian policy has at times been direct intervention in the Japanese stock market. In fact recently there have been many articles in the financial press along the lines of one in the Wall Street Journal of March 17, 1998 titles "Japanese Government May Prop Stocks."

These possibilities seem to have predictable effects in the markets for Japanese equity and for the currency required to buy Japanese stocks, the yen, as traders want to get hold of Japanese financial assets that either the government will buy or, like the yen, will benefit, perhaps only temporarily, from the anticipated government purchases. Of course there are other forces in the yen market also.

Finally, it should be noted that as hard as it might be to believe there are economists who think that market transactions can be non-productive. But there are and they propose introducing transaction taxes on such things as foreign exchange transactions, which they seem to find particularly evil. The leader of this anti-market group of economists if Nobel laureate James Tobin who is a leading American Keynesian Several years ago observing the tremendous volume of foreign exchange transactions that he did not believe were "productive" (no gains from trade?) he suggested a transaction tax on foreign exchange to reduce foreign currency speculation. Tobin doesn't seem to be very active anymore, but I have noticed that a book has recently been published containing papers on the Tobin" tax. Well, if Tobin and his students really wanted to reduce the amount non-productive foreign exchange transactions, they should consider steps to bring about the equality of interest rates internationally. This would prevent the "gifts," just like it did when the Fed's went to a uniform discount rate did in the 1920s. Or maybe one of the reasons the foreign exchange market has grown to be bigger than Las Vegas is that the central banks of the world add to the pot.

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Logon, learn, enjoy. Knowledge is too important to be left to the professors, or any other special interest group.