Comment on this article to comment@patrickminford.com
Strong pound cannot do a lot of harm in flexible economy New Labour inherited - Daily Telegraph 18 February 2002
Comments so far:
Tim Armstrong
Lee Oliver
anon
D T Cantwell
Peter Collins
Alan Musry
David Burnham
Roddy Campbell
Charles Corner
Peter Osler
Richard Wallis
J Alan Evans
Barry Kew
Colin Sutherland
Nicholas Rule
Peter
Turvey
Terence P O'Halloran
Andrew Surry
Andy Winterton
Sir,
Your comments regarding the 'forward rate' of Sterling are erroneous.
The difference between the spot and forward rates of exchange are purely and simply a reflection of the interest rate differential between the two currencies concerned.
At can be seen from todays prices (spot £/$ = 1.4325)
£1.000.000 @ 4.64%pa for 365 days on an annual actual/365 day basis = £46,400 or principal + interest £1,046,400.
$1,432,500 @2.42%pa for 365 days on an annual actual/360 day basis = $35,147.98 or principal + interest $1,467,647.90
1,467,647.90/1,046,400 = 1.4026
The difference between the the spot and outright forward is the forward premium of 1.4325-1.4026 = .0299
This price is quoted today as 302/299 on Reuters.
Clearly, I would prefer to take delivery of my £ today and enjoy a 2.22% interest rate differential in my favour and I would be prepared to pay for the. Or conversely, and more appropriately, if I were asked to take deleivery in a years time and lose this benefit, I would demand compensation. This is what the forward premium prices.
So todays outright forward price of 1.4026 means that the market expects the spot rate in one years time to be 1.4325!
The spot foreign exchange market is an almost perfect market. All known future influences on the value of the two currencies are already priced in.
Regards,
Tim Armstrong
Dear Mr. Armstrong,
Thank you. Of course you are quite right that covered parity holds so that the forward premium equals the interest differential. That is simply the result of arbitrage. However, the point is that someone must provide the forward cover; this involves someone taking uncovered speculative positions in the forward market which means that they must offer pounds for forward delivery at the rate they expect then to hold plus any risk-premium they require. This then gives rise to the implicit 'expected future rate' in the market. It is true I omitted the risk-premium; but that is found to be quite small in normal situations such as prevails with sterling currently,
yours sincerely,
Patrick Minford
I am afraid I have to disagree.
A foreign exchange posaition, be it spot or outright is an 'open risk' position.
In order to understand which market is arbitraging which you have to be aware of the size of the respective markets.
The forward FX market, which consists of the SIMULTANEOUS arrangement of spot and forward deals is immense. The market in outright forwards barely exists outside of textbooks.
In practise, if a speculator wishes to take a position in an outright forward, he is taking a spot position and rolling it forward with a forward FX deal. His outright position will be offset in the massive spot market and the equally massive forward FX market. It has to be remembered that the forward FX price is a function of the even more massive £ and $ money markets.
If we take a practical example.
Prudent and Co wish to buy a factory in the USA in one years time. They can either buy the dollars today and suffer the consequent interest rate cost, or they can buy them in a years time paying the premium away then.
If the company buys the dollars today the risk goes straight into the spot market.
If the company buys them today for settlement in years time the risk still goes straight into the spot market because Prudent and Co's counterparty will immediately split the position between in spot and forward books. Not only is this what happens in practise it is what is forced to happen because of the Bank of England 'open risk' limits for banks.
In recent times speculators (Mr Sorus) have taken speculative positions in the outright market. But the reason for this has been to render ineffective the ability of the central bank under attack to use interest rates as a means of defense. By dealing outright the speculator has effectively 'locked in' his funding cost.
I am sorry but you are simply technically wrong. Think about it; how does anyone get a covered position without someone taking an uncovered one?
See any textbook, including mine.
Patrick,
I am not wrong. Think of double entry book-keeping. For every buyer there must be a seller.
If you buy Dollars outright you have an uncovered open risk position.
I your counterparty, have an uncovered spot position and and uncovered forward position.
In answer to your question like this,
A buys an apple from B .
A is long 1 apple b is short 1 apple.
B buys an apple from c. B is square apples, C is short 1 apple.
C buys an apple from A. A is now square of apples, C is square of apples.
If you are covering a position you must be reveresing a previous one. So if you bought from 'the market', doesn't matter who, you must sell to 'the market'.
As a professor of economics why would you expect a currency to behave differenly to any other non-perishable goods. If I own steel bars which I and everybody else beleive are going to be worth twice as much next year I am not going to sell them. Nor is anyone else. So the price will go up now to reflect that future expectation. As the spot market is about a perfect a market as exists, that happens pretty much instantly.
Or think about it this way. Since covered arbitrage sets the forward equal to the spot plus the interest differential, what fixes the spot AND the forward levels? The value of a currency ultimately rests on what people think (speculatively) it is worth.
I absolutely agree with your final point.
The value of a currency (like a 1948 Beano) rests on what people speculatively think its worth.
My point is that the outright forward market does not actually exist.
That is not to say that one cannot take an outright forward position, of course one can. But the way that the currency markets handle that risk is by breaking the outright forwards into its constituent two parts, the spot foreign exchange deal and the forward FX deal.
I may not be adequately explaining what I mean by a 'forward' deal as distinct to an 'outright forward'.
An outright forward is a poisition whereby a party Buys or Sells a currency at a forward date, say 1 year.
A forward deal is a matched deal, whereby a party simultaneously Buys/Sells spot and Sells/Buys forward.
If I were your banker and you approached me to do an outright forward deal this is how it would be covered.
I Sell you GBP on 18/2/03 at 1.4000
With the market, I Sell and Buy £/$ Spot 1y Forwards at .0300 points my favour. The rates are Spot 1.4300, Forward 1.4000.
So the forward element of my trade with you is eliminated and I am now left short of £ in the spot market at 1.4300.
My point all along has been that the efficiencies of the forward currency markets render the concept of an outright forward redundant. There is 'open risk' FX whatever the settlement date, and there is interest rate risk.
The arbitrage that you refer to is almost instant.
For example,about two years before the Spanish Peseta joined the EMU there was a widespread perception, indeed certainty, that it would join at its current equilibrium rate. Almost uniquely this gave the market a forward price which was constructed from a spot and an outright forward. This did not agree with the spot price adjusted by the forward (cost of funding) price. What happened was that market interest rates (not official rate)moved within a couple of days to reflect this situation.
I'm sorry if I have appeared confrontational as that was certainly not my intention. All I was trying to say was 'Yes, but, in the real world it don't work like that.'
Regards,
Tim Armstrong
Thanks. Well at least we agree that the market thinks the pound in a year or two's time will be roughly where it is today - i.e. is in equilibrium!
Dear Patrick,
To paraphrase your column in Monday's paper, if I got a tenner for every time I had to read a complete misunderstanding of what the interest rate curve implies, I'd be a very rich man. Foreign exchange forwards, as well as interest rate futures, are not a prediction of where the market will be at point in the future. Both are reflections of the interest rate yield curve.
You write: Furthermore, the foreign exchange markets are apparently unconcerned. Concern should show up in the "forward rate" quoted for sterling in a year's time (for those say who want to be sure of what their new Spanish pied-a-terre will cost them in pounds). But sterling for February 2003 delivery is quoted at 2pc down on today's dollar rate, and 0.9pc down on today's euro rate - hardly serious overvaluation.
This is absolute rubbish. The outright forward rate reflects the cost of carry, nothing more. If Euro and sterling one-year deposit rates were the same, then the rate for sterling in one year's time against the euro would be basically the same as the spot rate. If sterling rates were higher, the outright rate would be discounted, as it is, to reflect the positive cost of carry earned by being long of sterling.
No wonder most traders take what economists predict with a barrel of salt. I hope this has been of help,
Regards,
Lee Oliver
Dear Mr. Oliver,
thank you but alas it is you that do not understand. (I write the same as I did to Tim Armstrong.) Of course you are quite right that covered parity holds so that the forward premium equals the interest differential.
That is simply the result of arbitrage. However, the point is that someone must provide the forward cover; this involves someone taking uncovered speculative positions in the forward market which means that they must offer pounds for forward delivery at the rate they expect then to hold plus any risk-premium they require. This then gives rise to the implicit 'expected future rate' in the market. It is true I omitted the risk-premium; but that is found to be quite small in normal situations such as prevails with sterling currently,
yours sincerely,
Patrick Minford
Have you never heard of options?
Outright forwards are incredibly poor "hedges".
Furthermore, I still think you are wrong in the statement: Concern should show up in the "forward rate" quoted for sterling in a year's time.
As you just said, the forward rate is derived from a simple mathematical formula. How can it possibly reflect 'concern'?
Regards,
Lee
Well, let's put it this way. The forward rate reflects future expectations; if it did not, people could make money by trading against it. Expected future rates are about the same as today's; hence the rate is in equilibrium.
I have looked at this again, and I really can't believe what a load of old tosh you have written.
If you want some contacts in the market, I can give you some. Otherwise, stick to reading books.
Failing that, you might want to try the BBA, ACI, BOE or perhaps even read a few of the meaningless text books you no doubt make your students read.
I reckon this is money for old rope.
I tell you what, I'll write as big a load of rubbish about economics as a markets expert, and give you a chance to get some back.
Otherwise, leave the pensioners who read The Telegraph alone. They are misinformed enough!
Sincerely,
Lee Oliver
You ask why British producers have not forced their workers to take wage cuts. How many workers in UK manufacturing have taken wage cuts of 100% (i.e., lost their jobs - many at an age which means they will never be able to use again their hard-won skills). Why is it that the UK labour force is increasingly de-skilled? When you go out to buy manufactured goods, where are they manufactured now? Why is Dyson moving away? Why are so many things imported from China?
Or, put it another way. You are a Professor: what are the salary levels in universities so poor, the working conditions so poor, and the working hours and stresses so high. Why do really good graduates now not consider such jobs?
I am chairman of governors at a state school (an excellent one), trying to appoint a new headteacher; why are the numbers of applications for headships down to about a tenth of the levels five years ago? I am told it is because of the horribly increased administrative burden, with more and more "administrators" in the DfES squatting on the backs of those who do the real work - i.e., by the cancer of administrators.
I suggest your optimistic tone in your article is based on out-of-date information.
email address supplied
Thank you. Yes, there are certainly plenty of things wrong, I would agree and indeed tried to say so. The fact remains the economy is cruising ahead with full employment and pretty reasonable performance on average. Markets are a down-to-earth overall judge.
Dear Mr Minford,
I read your article in today's Telegraph with amazement.
You should know better than to suggest that concerns about future currency movements have anything to do with forward exchange rates. As you know these depend solely on interest rate differentials.
If you did not know, what is the value of your other views? If you did know, you have shown yourself to be no better than the Government and its spin doctors.
Either way you have lost all credibility.
D T Cantwell
Dear Mr. Cantwell,
Thanks. A whole bunch of you have failed to understand about the role of speculative views in the formation of the forward rate. I copy to you what I have already written to a handful of others!
Of course you are quite right that covered parity holds so that the forward premium equals the interest differential.
That is simply the result of arbitrage. However, the point is that someone must provide the forward cover; this involves someone taking uncovered speculative positions in the forward market which means that they must offer pounds for forward delivery at the rate they expect then to hold plus any risk-premium they require. This then gives rise to the implicit 'expected future rate' in the market. It is true I omitted the risk-premium; but that is found to be quite small in normal situations such as prevails with sterling currently.
yours sincerely,
Patrick Minford
Your articles always cheer me up but I do not think you sound a loud enough warning note of the damage which will ensue from the current strengthening of trade union power. Combined with the huge cost burden to industry of complying with ludicrous Health and Safety requirements generated by the E U, I fear for the flexibility in the economy in 4 - 5 years time. Time to do away with regulation and any other form of Government interference with markets in manufacture and services.
Regards,
Peter Collins
Thank you. Yes, it is a worry. Blair does not seem to grasp the effect his ambivalent attitudes and legal reversals could have. The only hope is that market forces are now too entrenched to be seriously affected.
yours sincerely,
Patrick Minford
Attn Professor Patrick Minford
You comment that the foreign exchange markets are apparently unconcerned and cite as evidence the 'forward rate'.
It would appear that you have misunderstood what the forward rate actually is. It does not reflect in any way whatsoever what the market guesses will be the exchange rate on a future date. It is merely the spot rate with an adjustment factor to take account of the interest rate differential between two currencies.
Take for example a spot
rate of $1.40 = £1
A GBP interest rate of 4%
A USD interest rate of 2%
If you need £1m of dollars in 1 year's time you could buy them spot and put them on deposit for 1 year at 2% interest. You would end up in one year's time with $1.4m plus $28,000 interest total $1,428,000.
Alternatively you can buy the dollars forward to receive them in one year's time. The forward rate will take account of the fact that you will have the £1m on deposit for 1 year at 4% and earn £40,000 interest. Thus the applicable forward rate is calculated as 1,428,000 divided by 1,040,000 which is $1.3731 = £1 : your magic 2% discount which co-incidentally is the differential between the UK and US interest rates.
This must be the case because any variance from this forward rate will give rise to an arbitrage position whereby you will deposit the pounds or dollars and buy/sell forward to lock in an instant profit. The market will then move back to the equilibrium position.
In a perfect market future expectations are instantly reflected in the spot price. If the spot price adjusted for interest rate differences does not reflect expectations this can only be because there are other factors which are influencing market supply and demand.
Regards
Alan Musry
Dear Mr. Musry,
You have got the point as did some others. The forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
Dear Mr Minford,
Your message is preaching to the converted! You could also have mentioned the continuing level of inward investment as further evidence.
However, one of your points is, I believe, fundamentally incorrect. You say "the foreign exchange markets are apparently unconcerned. Concern should show up in the forward rate in a year's time...".
In all my regular business forward exchange transactions, the difference between the spot rate and the rate for delivery at a future date is only due to compensation for the interest rate differential between the two currencies. There is never any difference caused by market sentiment about the strength or weakness of either currency. Any forward exchange dealer would confirm this.
Regards,
David Burnham
Dear Mr. Burnham, thanks.
I agree about arbitrage between spot and forward. But the forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
I fully agree with your "If I had a tenner........" in today's Telegraph regarding the tedious mantra of sterling's over-valuation.
However, to use the forward exchange rate to support your argument is fallacious. The forward rate between fully convertible currencies is, and can only be, the spot rate plus or minus the interest rate differential between the two currencies concerned.
The reason sterling is at a 2% discount one year forward versus the dollar is because one year sterling interbank interest rates are 2% higher than the equivalent dollar rate, and for no other reason, because otherwise it would be a riskless arbitrage. If sterling rates were below dollars it would be at a premium forward.
Likewise sterling has traded at a forward discount versus the Deutsche Mark or Euro since 1993, not because the market "forecasts" a depreciation, but because our interest rates have been higher since then.
Sorry to be pedantic,
Roddy Campbell
Dear Mr. Campbell, thanks.
I agree about arbitrage of course. Let me put it this way, as I have to a few others.The forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
Dear Patrick,
What a refreshing article in the Telegraph today.
To read an economist (or a businessman) who is not trying to talk the Pound down is a joy to my heart. I have long felt that the British economy has got it wrong, and at present has a huge opportunity to become the off-shore "Taiwan" of Europe.
The wealth creators have for too long made the mistake of wishing a worthless monetary unit rather than looking at margins and quality to sell their product.
The British are snobs for selling is something too vulgar for their taste and they would rather pay a high commission to someone equipped only with a desk and telephone than soil their own hands. Napoleon was right on one thing - "A Nation of shopkeepers"
I buy expensive German and Japanese cutting tools, simply because they are the best, but I sell my own product Nationally and Internationally direct, because I know that it is the best and unequalled. I could ask a lot more for it but greed is not in my nature. Were I not 70 I could become a World Class manufacturer of fire pumps, but hemmed round with socialist legislation and highway robbery it is not worth the effort at my time of life.
Charles Corner.
Dear Charles,
thank you for your kind letter. It is not a bad economy for all our worries!
Patrick M.
I read with interest your article "strong pound cannot do a lot of harm in flexible economy New Labour inherited" published by the Daily Telegraph, February 18, 2002. I'll blame your sub-editor for that title.
Like yourself, there have been many occasions when I've wished "if I got a tenner for every time I have read an economic pundit saying...etc. etc, I'd be a rich man".
One common mistake made by "pundits" which I'd like to include in the give me a tenner category is that concerns of the currency markets should show up in the "forward rate". So in the case you were discussing, those concerns would be fears of a future devaluation/depreciation of the pound. Why do you feel the forward rate is the correct vehicle for these fears to be expressed?
Spot is the most liquid area of the foreign exchange market. The forward rate is calculable and based on arbitrage considerations between spot FX rates and market interest rates of the respective currencies involved in the spot price, over the maturity of the forward agreement.
You comment on the relatively small sterling devaluation expected by the forward markets, although I suspect your reasoning is flawed. Of course forward prices for sterling are lower than the spot price over the maturity (one year) you are considering. Interbank interest rates are higher in the UK than they are in the euro zone for a one-year period.
Expectations of the future value of the pound would not be expressed in the forward market without impacting spot and/or the interest rate markets. If there were a significant difference between spot and forward rates then there would be a corresponding significant difference between the respective interest rates attached to the currencies concerned. This could happen if say, a currency was being artificially supported (for example, by interest rates) in a fixed exchange rate regime, but was expected by the markets to devalue in the near future.
Imagine a situation where say the pound was expected to join the euro in one year's time at a level, say, 10 per cent lower than current rates.
Are you suggesting this would first show up in the forward price and stick out in respect to the spot price? Rather, there is a consistent arbitrage relationship between spot, interest rates and forwards. Any pricing anomaly would be ephemeral and there would be no prolonged arbitrage or risk free profit potential.
If the forward rate expressed
this view without any movement in market rates elsewhere, dealers would:
Sell the pound (at spot rates).
Buy the euro.
Receive one-year euro rates of interest. Pay one year sterling rates of interest.
Lock into this marvelous forward rate agreement to buy back the pound in a year's
time, 10 per cent cheaper than it was sold it for, way outdoing any interest
rate considerations.
Are you suggesting that interest rate markets wouldn't adjust to expectations expressed by the forward rate market? Are you implying that spot would not move as quickly as the forward price to discount an expected devaluation?
The truth is that the forward price is a mathematical function of spot rates and available interest rates. Interest rate stability assumed, an expected devaluation of the pound would be expressed in the spot and the forward market simultaneously, precluding arbitrage.
£10 pound please.
Yours sincerely
Peter Osler
Dear Mr. Osler,
You have got the point. The forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
Dear Professor Minford,
I would be more than happy to support your being awarded £10 each time an economist prognosticates on the over-valued pound if for each party-political point and reference to nannyism that you make you could be sent to visit nanny.
Such a trade-off would allow the Political Right to applaud a deserved increase in wealth for its favourite Professor of Economics, whilst the Left would be comforted by the image of one of its demons over nanny's knee experiencing re-education via the back of a hairbrush.
It seems to me that you condemn the Government both for sins of commission and omission. Whether it chooses to do something or nothing any credit thus passes to the market, which former Governments of another hue have set free socially, culturally and legislatively.
Although I enjoy your articles I find difficulty in avoiding the conclusion that what you really would like to say is "Economics is bunk". The attraction to me is indeed that your articles encompass far more than Economics. Unfortunately your view of the world rarely coincides with mine. Surely something far more permanent than wage-cuts is evident? Employment for instance in Insurance and Banking is in crisis. Wages no longer become an issue when the job itself disappears.
Equally if the economy is somehow okay then surely even in the most negative of senses the Government must merit a little praise?
My musings are intended for interest only. I hope they amuse you.
Yours sincerely,
Richard Wallis
Dear Mr. Wallis, thank you, your musings are a pleasure!
Well, surely I have implicitly given the government some credit? I mean they have left intact an awful lot of what they inherited plus making monetary policy professional and independent. I worry about their reregulation. But, yes, as you suspect this piece was more an attack on punditry and in defence of economics that takes market processes seriously than an onslaught on Mr. Brown,
yours sincerely,
Patrick Minford
February 22, 2002
Dear Professor Minford,
The praise you implicitly give the Government for not ruining things reminds me of my Politics tutor's insistence that not voting is a political act. Not voting is almost as slight a contribution as the Government leaving things alone. It smacks of a place on the substitute's bench of life.
It is incidentally always disappointing to find that someone demonised by the political Left - where I have found myself all my life - is actually rather likeable!
I do not know how my fantasy credibility will survive this admission. With Nanny's hairbrush about to fall I fear I shall be forced to step forward and yell, "Nanny spare that Economist!". How will I ever hold up my head?
I am glad my letter amused you.
Best wishes
Richard Wallis
Thanks! Very kind,
Patrick M.
Since when has the forward rate in the Foreign Exchange market been a reflection of expectations (or a prediction) as to where a currency will tade in the future ? ........
it is a pure reflection of the current spot rate plus or minus interest rate differentials.
J Alan Evans
Dear Mr. Evans,
a number of people have written about this covered arbitrage point (see the correspondence on my webpage www.patrickminford.com). Let me explain further as I have done to some. The forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
Dear Patrick Minford,
In you article today in the Daily Telegraph may I comment on two of the points covered:
It is not only The Economist and FInancial Times who believe our exchange rate is too high - This is the regularly stated view of The Institute of Directors and The Confederation of British Industry - however wrong the view may be!
Barry Kew
Dear Mr. Kew, Thank you.
Well, it is true that the Conservatives were a bit slow on the unemployment issue. But by 1986 they (David Young at the Manpower Commission) were indeed spreading the message of get a job - remember Restart?
And I agree that view of overvaluation is quite widespread, even among friends of industry and free markets. Such is the way with intellectual error! Basically, it stems from a paternalistic view of economics- that people don't know what is what and therefore markets get prices wildly wrong for long periods. Such views die hard.
yours sincerely,
Patrick Minford
Dear Mr. Minford,
I was delighted that you rubbished the 'high pound 'lobby. We really need pragmatic comments like yours to counter the nonsense spouted by neo economists. But I was rather surprised that you seem to think that forward foreign exchange rates are a function of the market's view. In fact they are purely a function of the interest rate differential between the currencies.
When I headed the financial futures at Laurie Milbank, I had the pleasure of attending several strategy meetings there with you.
Regards,
Colin Sutherland
Dear Mr. Sutherland, how nice to hear from someone from Laurie Millbank of old! Good times!
Several people have written about this covered arbitrage point. Of course I agree about that. let me explain, as I have now done to a few others (more gory details on my webpage for this www.patrickminford.com). The forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
Professor Minford,
Have to disagree with one strand of your article this Monday, where you suggested that the Forward Exchange (FEC) Rate is the Market's view or even 'a crystal ball' prediction of what the spot rate will be in 1/3/12 months' time.
The FEC quoted in the money pages is in effect today's spot rate on delayed settlement terms, the forward premium or discount being determined by comparable deposit interest rate differentials.
Thus 12 m £ Libor
is 4.646%, 12m $ LIBOR 2.4925%, diff. is 2.15%;
spot $ 1.43225, 12m $ 1.4031, cost of (1.4325-1.4031)/1.4031 = 2.10% FEC at
premium to spot (all on % p.a.).
Govt. actions will affect deposit rates, both in their domestic and in the non-controlled markets for the currency abroad. If a govt.'s policies are attractive to foreign investors, that Govt. will not have to bid up to attract non-resident funds. I certainly agree with your closing sentence.
Regards
Nicholas Rule
Dear Mr. Rule, thanks.
A few people have worried about this - and I have written in the following terms (see my webpage www.patrickminford.com for the full correspondence). I agree about arbitrage between spot and forward. But the forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
I cannot resist the temptation to comment on your Telegraph article on 18 Feb.
You imply that forward rates for foreign exchange reflect the consensus of consumers on future exchange rates. Whilst this is unarguable in a narrow sense - if consumers thought differently, they would have an opportunity for arbitrage - the consumer has a simpler option to buy Euros now, and invest in that currency.
I have always understood that forward exchange rates are set by interest rates differentials. Thus the 0.9% relative devaluation of sterling the euro arises because in one year a holder of _ would earn 0.9% more than a holder of Euro. If forward exchange rates futures were not consistent, there would be an opportunity for risk-free arbitrage which would quickly close the gap, either by changing interest rates or by changing the forward rate.
The banking market is much more influential and liquid than the private consumer!
Peter Turvey
Covered arbitrage is a well-known fact and of course I am fully aware of it; it has been in the Liverpool Model for 20 years! (I have written in similar vein to a good few this week!) The point here is about the setting of the forward rate. The forward rate reflects expectations of what will happen; the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
February 21, 2002
There are (at least) four different markets, viz
Each is a market with buyers and sellers. All four markets have to be mutually consistent, otherwise the arbs will intervene.
My point is that we need to ask which of the markets are the drivers, and which the followers. Surely the spot market is king, with the two interest rates heavily influenced by the Central Banks.
It follows that the forward rate is the balancing item, and price is governed by the possibility of arbitrage, not the (future) consumers implied by your article. If a future consumer thinks there is an anomaly in the market he can trade (or not) as he wishes, but there will never be enough of them to influence the equilibrium.
Or do you think that prices in the spot market are derived from forward rates and interest rates?
Peter Turvey
Yes! The point is that if the forward rate differs from the expected future spot rate there is an opportunity to make money - by anyone anywhere in the world. A risk-premium will insert a wedge but otherwise this ensures that forward=expected future spot.
Patrick Minford
Thank you for a common sense and pragmatic view.
In 1965 when I was in Germany there were DM11.21 to the Pound and 10 Guilders. The strengthening of those two currencies over the ensuing 10 years also strengthened the respective national standard of living whilst the British economy went into reverse.
Your comments are very apposite for those who comment, many from a standpoint of "authority", based upon perception and hypothesis whilst those in command of the facts appear, just as equally, to be ignored.
Yours sincerely
Terence P O'Halloran BSc
Dear Mr. O'Halloran,
many thanks for your kind words. The DM and guilder's strength at that time were symptoms of the good policies they were pursuing - the wunderswirtschaft etc. We had got it rather wrong in those days, sadly.
However, now the roles are reversed,
yours sincerely,
Patrick Minford
Dear Sir,
I read with interest your article in The Daily Telegraph of 18th February on the strength of the pound.
One comment, however, I would like to take issue with, namely that "Forward Rates" reflect the market expectations of future currency movements. My experience is that the biggest determination of the forward rates is the differential in interest rates.
Yours faithfully
Andrew Surry
Dear Mr. Surry, Thanks.
Quite a few people took issue on this as you will see on www.patrickminford.com from the correspondence. Forgive me for repeating myself but of course I agree entirely about the covered interest differential being forced to zero by arbitrage; my arguments assume that.
But matters go further. The forward rate reflects expectations of what will happen (otherwise anyone anywhere in the world could make money by specuating against the forward rate); the spot rate then also adjusts, is arbitraged, to be consistent with it.
The point I was making is this. The market's view of where the pound will be in a year's time is reflected in the forward market. Therefore the market believes the pound is approximately in equilibrium otherwise it would expect something much lower. (If one looks five years ahead the point is even more powerful as long term interest differentials are very small; effectively the market sees no change and therefore expects the current rate to be the equilibrium as far as the eye can see.)
yours sincerely,
Patrick Minford
Dear Patrick,
Your article in the telegraph is accurate as usual. The strength of sterling has been used as a lame excuse for far too long by businesses with need to apportion blame. It is interesting how often one sees currency movements listed as the reason for business under-performance. This is despite the business management being responsible for managing the risks of their company, and currency is just one more risk to manage. Thus to blame currency is to admit failure to manage the currency risk. Interestingly, one rarely sees a company explain that their results would have been terrible if it had not been for a lucky currency move!
However, your comment that future currency prices, being close to present levels, indicate confidence in the continuing levels of sterling is not as clear as it could be. Forward currency prices are a function of today's prices and the interest rates of the two currencies in question. Buying sterling for dollars one year forward is the economic equivalent of buying sterling for dollars today, with the sterling then placed on deposit for a year and the dollars borrowed for a year. In fact, this is how a bank would hedge a forward trade. Thus, the difference between spot prices and forward prices is a mechanical derivative of the interest rate differential, and is not a prediction of where rates will be in a year's time.
However, it would be fair to say that if the vast majority of traders felt that sterling will be lower in a year's time, then they would sell sterling forward. Due to the mechanism described above, this would have the effect of lowering the spot price now. In this way, it is more accurate to state that the present spot exchange rate includes the present positions and all the future expectations of all market participants. Commentators who say that the most market participants expect a particular price to move in one particular direction are wrong. If the vast majority of participants expected a particular move, it would have already happened!
Please keep up the work of explaining the importance of economics to everyday life!
With best regards
Andy Winterton
Dear Mr. Winterton,
thanks for your letter and kind words. Of course I accept the spot-forward arbitrage relationship; and yes, I agree that what happens is that the forward rate reflects the expected future spot rate (otherwise there would be profitable speculative postiions on the forward rate) and that this in turn forces the spot rate into line via arbitrage.
Given this, maybe a better way to have put my meaning would have been to say: the forward rate reflects where the markets think sterling will be, and look how this rate up to five years ahead is roughly where the spot rate today is. This expected future rate must be where the market thinks equilibrium is since it thinks that the rate will settle there so far ahead.
Therefore the spot rate is not far from equilibrium!
yours sincerely,
Patrick Minford