forex

New Rule Requires Better Reporting to Retail Forex Investors

Forex Dealer Members (FDMs) are subject to NFA oversight because they are required to be registered with the CFTC and also to be members of the NFA. On June 1 of this year, FDMs will need to comply with heightened disclosure requirements to their retail forex investors. These greater requirements are designed to promote greater transparency into the retail investors’ account activity and balances. The new rule is Rule 2-44. More information can be found in the NFA release below:

NATIONAL FUTURES ASSOCIATION
FOREX CUSTOMER ACCOUNT STATEMENTS

In these challenging times, the need for investors to monitor and understand the activity occurring in their trading accounts has never been greater. National Futures Association (NFA) believes that customer account statements should contain clear, concise and complete information. The more difficult a customer account statement is to understand, the easier it is for a broker or account manager to mislead a customer about the value of a customer’s account and the success of the customer’s trades.

In an effort to provide retail forex customers with clearer, more uniform confirmations, daily statements and monthly statements, NFA has developed specific customer reporting requirements for its Forex Dealer Members (FDMs).

FDMs must currently provide written confirmations to customers within one business day after any activity in the customer’s account, including offsetting transactions, rollovers, and deliveries, and these confirmations must include details of the transaction and any related costs. Effective June 1, 2009, a new rule clarifies that activity requiring a confirmation includes option exercises, option expirations, trades that have been reversed or adjusted, and monetary adjustments. The new rule specifies that the confirmations must contain the following information regarding the transaction and the funds in the account:

• Transaction date;
• Transaction type (e.g., new position, offsetting position, rollover, adjustment);
• Currency pair;
• Buy or sell (if a new or offsetting position);
• Size;
• Price or premium (for new or offsetting positions or price adjustments);
• Price or premium change (for price adjustments);
• Monetary adjustments (debit or credit);
• Net profit or loss for offsetting positions; and
• Charges for each transaction (e.g., rollover interest and/or fees).

In addition, FDMs are currently required to send monthly statements to all customers who have accounts that have open positions at the end of the month or changes in the account balance or equity since the prior statement. Quarterly statements are required for all other open accounts. The new rule states that monthly or quarterly statements must contain the following information regarding the transactions during the reporting period and the funds in the account:

• The account equity at the beginning of the reporting period;
• All initiating or offsetting transactions, deliveries, option exercises, or option expirations that occurred during the reporting period, with the following information for each: date, currency pair, buy or sell, size, and price or premium (with any price or premium adjustment noted);
• All open positions in the account, with the following information for each position: date initiated, currency pair, long or short, size, price or premium at which it was initiated (with any price or premium adjustment noted), and the unrealized profit or loss;
• All deposits and withdrawals during the reporting period;
• All other monetary adjustments (debits and credits) to the account;
• The amount of cash in the account (excluding non-cash collateral and unrealized profits and losses);
• A breakdown by type of all fees and charges during the period, including commissions and interest expense or rollover fees; and
• The account equity at the end of the reporting period.

As of June 1, 2009, FDMs must also provide daily statements showing the account equity as of the end of the day. FDMs may provide the daily statements online or by other electronic means as long as they are readily accessible to customers. FDMs may provide confirmations and monthly/quarterly statements online or transmitted by other electronic means if the customer consents to the specific method used.

Conducting Due Diligence

NFA reminds all individuals who trade forex to conduct business with a regulated forex firm - i.e., a bank, an insurance company, a broker-dealer or a futures commission merchant. If the firm is a futures commission merchant, it is required to be registered with the Commodity Futures Trading Commission and to be a Forex Dealer Member of NFA. You can easily check an FDM’s registration status through NFA’s Background Affiliation Status Information Center (BASIC), available through NFA’s website (www.nfa.futures.org).

Anyone who has any questions or concerns regarding their forex dealer should contact NFA either through our website (www.nfa.futures.org) or by calling our Information Center toll-free at (800) 621-3570 during normal business hours.

NFA is a self-regulatory organization subject to oversight by the CFTC. NFA’s primary mission is to protect investors and maintain market integrity.

Law and Regulations

CFTC Seeks Public Comment on Possible Changes to Regulations for Investment of Funds Deposited with Clearing Organizations and Futures Commission Merchants

The Commodity Futures Trading Commission (CFTC) has approved for publication in the Federal Register an advance notice of proposed rulemaking seeking public comment on possible changes to its regulations regarding the investment of customer funds segregated pursuant to Section 4d of the Commodity Exchange Act and funds held in an account subject to Regulation 30.7.

Regulation 1.25 provides that a derivatives clearing organization or a futures commission merchant holding customer segregated funds mayinvest those funds in certain permitted investments subject to specified requirements that are designed to minimize exposure to credit, liquidity, and market risks. The CFTC is considering proposing amendments that would revise the scope and character of these permitted investments.

Additionally, in conjunction with its consideration of possible amendments to Regulation 1.25, the CFTC is considering applying the investment requirements of Regulation 1.25, including any prospective amendments, to investments of funds held in accounts subject to Regulation 30.7 (accounts for foreign futures and options).

The CFTC seeks public comment on this action before issuing any proposed rule amendments. The comment file will remain open for 60 days following publication in the Federal Register. Copies of comments may be obtained by contacting the CFTC’s Office of the Secretariat, Three Lafayette Centre, 1155 21st Street, NW, Washington, DC 20581, 202-418-5100 or by accessing the CFTC’s website, www.cftc.gov. Interested parties may submit their comments electronically at secretary@cftc.gov. All comments received will be promptly posted on the CFTC’s website.

Regulatory Agency Proposes Leverage Limit

FINRA Member firms which engage in off-exchange forex transactions with retail customers may face leverage limits if a new FINRA proposed rule is adopted. The new rule would limit the leverage which a member firm could provide to a retail forex investor (i.e. an investor who is not an eligible contract participant) to 1.5 to 1. Many forex dealers currently provide leverage of 100 to 1 or more. FINRA cites the volatility of the forex markets and investor protection as reasons for the very low leverage limits. FINRA will beaccepting comments on this proposal until February 20, 2009.

Forex Hedge Fund Information and Resources

Many forex professionals have experienced a great deal of success trading and investing in the forex markets. These professionals, however, often aren’t sure where they should go for great information on forming a forex hedge fund. They have compiled the resources below for forex managers.

How to Start a Forex Hedge Fund

Once a forex manager is committed to start a forex hedge fund, he will need to retain an attorney who is familiar with both the securities laws involved in forming hedge funds as well as the forex laws which the manager must be aware of. Both ofthese sets of laws are important for the forex manager to observe.

Which Forex Dealer Member should the manager choose?

In general the forex manager should go with the forex dealer member (formerly known only as a futures commission merchant) who provides the best pip spreads. Some forex dealer members will also have a pip rebate program, but these are not very prevalent and many forex dealer members do not have these types of programs. Please contact to discuss your choice of forex dealer member. Many times they can provide managers with better spreads through network.

Most Important Part of the Process

The process of forming a forex hedge fund canbe long, especially if there is registration issues involved. The manager should consider the following:

1. Do you have investors who are ready t o in vest?
2. Do you have office space and the proper equipment to trade?
3. Do you need support staff to support the fund and interact with investors?
4. Do you have forex risk management procedures?
5. Do you have a competent forex attorney?
6. Do you have a good forex dealer memb er who provides you with great rates?

There are other questions which can be considered as well.Their attorneys can help you think through all of the items necessary to establish a successful forex hedge fund. Please contact for a free forex consultation. Typically the consultation will last for half an hour or less and they will provide you with an overview of the process and a list of next steps.

Forex vs. Stock

Trade around the clock The forex market is a near-seamless 24-hour market. Subject to available liquidity, FXCM offers trading from Sunday, starting after 5:15 PM EST, until Friday, 4PM, EST (FXCM Client Service is available 24/7). With the ability to trade around the clock, currency traders have the advantage of customizing their own trading schedule; they can usually get in or out of the market at any time without waiting for an opening bell or encountering a market gap. While trading stocks after usual market hours is possible, very often that possibility is negated by a lack of order flow or a drastic widening of the bid-ask spread. Pay No Commissions* In the forex market costs are confined to the bid-ask spread. FXCM charges no commission or additional transaction fees, and its customers trade on spreads provided to FXCM by some of the world's largest banks via the FX Trading Station. In the stock market, “no-fee” programs are frequently offered only with provisos mandating minimum account balances or minimum trades per month. No uptick rule Unlike the equity market, there is no restriction on short selling in the forex currency market, no matter which way the market is moving. Since currency trading involves buying one currency and selling another, a trader has the same ability to trade in a rising market as in a falling one. Forex Market Information Easily Accessible Information about stocks is abundant, but so are the stocks. Finding a trade opportunity in the equities markets may mean sifting through data on thousands of stocks, while the forex trader has only six major currencies to research. Additionally, the vital information that moves equity markets, such as revenues and profits, is proprietary and private. In contrast, virtually all of the news that bears on the forex market is in publicly disseminated reports from governments or research institutions, and released to everybody at the same time. We feel that the knowledge you've gained in analyzing stocks can easily be transferred to the forex market. Many of the economic indicators familiar to equity traders, such as payroll data and interest rates, affect the currency markets. And many technical traders have found the forex market to be particularly attractive, since currencies respond well to many of the common technical indicators, such as MACD, RSI, and Candlestick charting. High Risk Investment Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot transactions has the second largest turnover by volume after Swap transactions among all FX transactions in the Global FX market.

Forward

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties.

Future

Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

Swap

The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.

Option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

Exchange-Traded Fund

Exchange-traded funds (or ETFs) are open ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500 (e.g., SPY), but recently they are now replicating investments in the currency markets with the ETF increasing in value when the US Dollar weakens versus a specific currency, such as the Euro. Certain of these funds track the price movements of world currencies versus the US Dollar, and increase in value directly counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated investors and speculators.

Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main professional speculators.

Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators allegedly made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Given that Malaysia recovered quickly after imposing currency controls directly against IMF advice, this view is open to doubt.

An algorithmic trader needs to be mindful of potential fraud by the broker. Part of the weekly algorithm should include a check to see if the amount of transaction errors when the trader is losing money occurs in the same proportion as when the trader would have made money.

While the growth in electronic trading has stimulated the application of Algorithmic Trading, it has lead to some abuses of the term as well as the scale and mode of its application, more so perhaps in the context of foreign exchange trading as in any other asset class. In part this may be explained because the buy side institutions and proprietary trading groups increasingly demand the ability to develop and customise complex trading strategies in place of ‘off the shelf’ algorithms. They require the ability to access not just multiple markets, but to trade across asset classes, through a range of applications.

Algorithmic trading—placing a buy or sell order of a defined quantity into a quantitative model that automatically generates the timing of orders and the size of orders based on goals specified by the parameters and constraints of the algorithm—is not applied exclusively to programme trades to achieve better execution in the foreign exchange asset class. The term is applied to facilities such as black box, white box trading, quantitative trading and programme trading. While they are all perceived as a mechanism, which theoretically could one day dis-intermediate the human trader entirely. They are all different but share commonality only to the extent they deploy algorithms in their application:

• A black box is a closed system as far as understanding about how it works. The user has to have blind faith in the system writers’ skills and track record.
• A white box is the opposite. It is open to the user‘s understanding. The basic concepts regarding the philosophy and thinking that has gone into this trading system are explained in the training package.
• Programme trading is a generic term for a variety of stock market strategies whose aim is to automatically rebalance the weightings of assets in a portfolio by shifting the holding of shares, options, and futures. They are triggered and implemented automatically, once the parameters have been set.
  • A quantitative trading is the application of mathematical models to assist the activities of traders.
    Fx differs from financial instruments in the application of algorithmic trading:
    
• Foreign exchange is a commodity not a financial instrument, though it can be packaged into a financial instrument, principally as an exchange traded instrument.
• As a commodity foreign exchange is not exchange traded. It is traded OTC (Over The Counter) worldwide in an unquantified number of locations only constrained by the availability and depth of liquidity.
• • Foreign exchange is overwhelmingly conducted on a proprietary basis not on an agency basis.
  • Foreign exchange has too many tradable permutations for the application of the Algorithmic rules, which apply to financial instruments, unless the objective is as specific as trading a single block of currency to a single value date. Money managers have far more complex requirements, since they might be trading not one currency block but several blocks and even several blocks that might be broken out across hundreds of accounts. Between the blocks there are netting and aggregation opportunities that do not exist in equities due to the definition of how equity works. To this may be attributed a failure in deployment of order management systems (OMS) for trading FX.
  • Banking consolidation has ensured that liquidity is controlled at the price at which liquidity is available. They are not, as yet, enthusiastic about the adoption of algorithmic trading in the foreign exchange markets.

MiFID (the EU Market in Financial Instruments Directive) through its introduction of pre-trade transparency may accelerate the deployment of algorithmic trading in financial instruments but it will not apply to foreign exchange unless it is packaged as a financial instrument. So where is algorithmic trading heading in the foreign exchange market?

Historically, the major banks have controlled the price spread in the foreign exchange markets. Algorithmic trading eases that power away from them. It enables end buyers and sellers to time their entry and exit to the market. The major banks may limit access to trading platforms in the short term but ultimately they will encounter competition investigation. Electronic FX is gradually being adopted, perhaps more slowly than across other asset classes, but that heralds the growth of algorithmic trading.

Hedge funds appear to be the drivers of algorithmic trading on the buy side of the business. They are dependent on the major banks for a range of services. Have they yet proved themselves as more than a passing investment fashion? Mainstream adoption of algorithmic trading by corporate treasuries would substantially alter the buy side of the foreign exchange market. It would be a more efficient, faster, consolidated, cost-effective way for corporate treasuries to satisfy their foreign exchange demands. This may be the answer to more widespread adoption of algorithmic trading in the form of timed entry and exit in to the foreign exchange markets.

A consumer price index (CPI) is a measure of the average price of consumer goods and services purchased by households. A consumer price index measures a price change for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation). It is a price index determined by measuring the price of a standard group of goods meant to represent the typical market basket of a typical urban consumer.Related, but different, terms are the CPI, the RPI, and the RPIX used in the United Kingdom. It is one of several price indices calculated by most national statistical agencies. The percent change in the CPI is a measure of inflation. The CPI can be used to index (i.e., adjust for the effects of inflation) wages, salaries, pensions, and regulated or contracted prices. The CPI is, along with the population census and the National Income and Product Accounts, one of the most closely watched national economic statistics.

Introduction

Two basic types of data are needed to construct the CPI: price data and weighting data. The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. These weights are usually based upon expenditure data obtained for sampled decades from a sample of households. Although some of the sampling is done using a sampling frame and probabilistic sampling methods, much is done in a commonsense way (purposive sampling) that does not permit estimation of confidence intervals. Therefore, the sampling variance is normally ignored, since a single estimate is required in most of the purposes for which the index is used. Stocks greatly affect this cause.

The index is usually computed yearly, or quarterly in some countries, as a weighted average of sub-indices for different components of consumer expenditure, such as food, housing, clothing, each of which is in turn a weighted average of sub-sub-indices. At the most detailed level, the elementary aggregate level, (for example, men's shirts sold in department stores in San Francisco), detailed weighting information is unavailable, so elementary aggregate indices are computed using an unweighted arithmetic or geometric mean of the prices of the sampled product offers. (However, the growing use of scanner data is gradually making weighting information available even at the most detailed level.) These indices compare prices each month with prices in the price-reference month. The weights used to combine them into the higher-level aggregates, and then into the overall index, relate to the estimated expenditures during a preceding whole year of the consumers covered by the index on the products within its scope in the area covered. Thus the index is a fixed-weight index, but rarely a true Laspeyres index, since the weight-reference period of a year and the price-reference period, usually a more recent single month, do not coincide. It takes time to assemble and process the information used for weighting which, in addition to household expenditure surveys, may include trade and tax data.

Ideally, the weights would relate to the composition of expenditure during the time between the price-reference month and the current month. There is a large technical economics literature on index formulae which would approximate this and which can be shown to approximate what economic theorists call a true cost of living index. Such an index would show how consumer expenditure would have to move to compensate for price changes so as to allow consumers to maintain a constant standard of living. Approximations can only be computed retrospectively, whereas the index has to appear monthly and, preferably, quite soon. Nevertheless, in some countries, notably in the United States and Sweden, the philosophy of the index is that it is inspired by and approximates the notion of a true cost of living (constant utility) index, whereas in most of Europe it is regarded more pragmatically.

The coverage of the index may be limited. Consumers' expenditure abroad is usually excluded; visitors' expenditure within the country may be excluded in principle if not in practice; the rural population may or may not be included; certain groups such as the very rich or the very poor may be excluded. Saving and investment are always excluded, though the prices paid for financial services provided by financial intermediaries may be included along with insurance.

The index reference period, usually called the base year, often differs both from the weight-reference period and the price reference period. This is just a matter of rescaling the whole time-series to make the value for the index reference-period equal to 100. Annually revised weights are a desirable but expensive feature of an index, for the older the weights the greater is the divergence between the current expenditure pattern and that of the weight reference-period.

Example: The prices of 95,000 items from 22,000 stores, and 35,000 rental units are added together and averaged. They are weighted this way: Housing: 41.4%, Food and Beverage: 17.4%, Transport: 17.0%, Medical Care: 6.9%, Other: 6.9%, Apparel: 6.0%, Entertainment: 4.4%. Taxes (43%) are not included in CPI computation.

These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.

1. Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
2. Economic conditions include:

   Government budget deficits or surpluses

   The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.

   Balance of trade levels and trends

   The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.

   Inflation levels and trends

   Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising . This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.

   Economic growth and health

   Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.

   Productivity of an economy

   Increasing productivity in an economy should positively influence the value of its currency. It affects are more prominent if the increase is in the traded secto

   
   

   Economic Indicator

   An economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance.

   Economic indicators include various indices, earnings reports, and economic summaries, such as unemployment, housing starts, Consumer Price Index (a measure for inflation), industrial production, bankruptcies, Gross Domestic Product, broadband internet penetration, retail sales, stock market prices, and money supply changes. Economic indicators are primarily studied in a branch of macroeconomics called "business cycles". The leading business cycle dating committee in the United States of America is the National Bureau of Economic Research.

   The Bureau of Labor Statistics is the principal fact-finding agency for the U.S. government in the field of labor economics and statistics. Other producers of economic indicators includes the United States Census Bureau and United States Bureau of Economic Analysis.

   Economic indicators fall into three categories: leading, lagging and coincident.

   Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy, thereby providing information about the current state of the economy. Personal income, GDP, industrial production and retail sales are coincident indicators. A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle.

Economic Data

Economic data are usually numerical time-series, i.e., sets of data (covering periods of time) for part or all of a single economy or the international economy. When they are time-series the data sets are usually monthly but can be quarterly and annual. The data may be adjusted in various ways (for ease of further analysis), most commonly adjusted or unadjusted for seasonal fluctuations.

Economic data may also describe functions or inter-relationships between variables [where the inter-relationships may be theoretical (e.g. a production function) rather than factual], and they may describe a static as opposed to a dynamic relationship (e.g., an input-output matrix or a foreign exchange correlation matrix^[1] as opposed to, e.g.. a series showing changes of automobile output over time).

Thousands of data sets are available. At the level of an economy, these are compiled by use of national accounts. Such data include the major components of Gross National Product, Gross National Expenditure, Gross National Income, and a whole panoply of series including output, orders, trade, confidence, prices and financial series (e.g., money and interest rates). At the international level there are many series including international trade, international financial flows, direct investment flows (between countries) and exchange rates.

Within a country the data series are usually produced by one or more statistical organisations, e.g., a government or quasi-government organisation and/or the central bank. International statistics are produced by several international bodies and firms, including the International Monetary Fund and the Bank for International Settlements.

Many methods can be used to analyse the data. These include, e.g., time-series analysis using multiple regression, Box-Jenkins analysis, seasonality analysis. Analysis may be univariate (forecasting from one series) or multivariate (forecasting from several series). Economists, econometricians and financial experts build what can be very complex models that incorporate raw economic data, adjusted economic data, and relationships that they have estimated, to model economic developments. These models may be partial, aimed at examining particular parts of an economy or economies, or they may cover a whole economic system and forecast, e.g., demand, prices and employment.

Economic Data Issues

Good economic data is a precondition to effective macroeconomic management. With the complexity of modern economies and the lags inherent in macroeconomic policy instruments, a country must have the capacity to promptly identify any adverse trends in its economy and to apply the appropriate corrective measure. This cannot be done without economic data that is complete, accurate and timely.

Increasingly, the availability of good economic data is coming to be seen by international markets as an indicator of a country that is a promising destination for foreign investment. International investors are aware that good economic data is necessary for a country to effectively manage its affairs and, other things being equal, will tend to avoid countries that do not publish such data.

The public availability of reliable and up-to-date economic data also reassures international investors by allowing them to monitor economic developments and to manage their investment risk. The severity of the Mexican and Asian financial crisis was made worse by the realization by investors that the authorities had hidden a deteriorating economic situation by slow and incomplete reporting of critical economic data. Being unsure of exactly how bad the economic situation was, they tried to withdraw their assets quickly and in the process caused further damage to the economies in question. It was the realization that data issues lay behind much of the damage done by these international financial crises that led to the creation of international data quality standards, such as the IMF’s General Data Dissemination System (GDDS).

Inside a country, the public availability of good quality economic data allows firms and individuals to make their business decisions with confidence that they understand the overall macroeconomic environment. As with international investors, local business people are less likely to over-react to a piece of bad news if they understand the economic context.

The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or opportunity cost the cost of purchasing a particular security rather than an alternative. For most investments, the cost of carry generally refers to the risk-free interest rate that could be earned by investing currency in a theoretically safe investment vehicle such as a money market account minus any future cash-flows that are expected from holding an equivalent instrument with the same risk (generally expressed in percentage terms and called the convenience yield). Storage costs (generally expressed as a percentage of the spot price) should be added to the cost of carry for physical commodities such as corn, wheat, or gold.

The cost of carry model expresses the forward price (or, as an approximation, the futures price) as a function of the spot price and the cost of carry.

where F is the forward price, S is the spot price, e is the base of the natural logarithms, r is the risk-free interest rate, s is the storage cost, c is the convenience yield, and t is the time to delivery of the forward contract (expressed as a fraction of 1 year).

The same model in currency markets is known as interest rate parity.

For example, a US investor buying a Standard and Poor's 500 e-mini futures contract on the Chicago Mercantile Exchange could expect the cost of carry to be the prevailing risk-free interest rate (around 5% as of November, 2007) minus the expected dividends that one could earn from buying each of the stocks in the S&P 500 and receiving any dividends that they might pay, since the e-mini futures contract is a proxy for the underlying stocks in the S&P 500. Since the contract is a futures contract and settles at some forward date, the actual values of the dividends may not yet be known so the cost of carry must be estimated.Carry (investment)

Carry(Investment)

• The nominal exchange rate e is the price in foreign currency of one unit of a domestic currency.
• The real exchange rate (RER) is defined as , where P^f is the foreign price level and P the domestic price level. P and P^f must have the same arbitrary value in some chosen base year. Hence in the base year, RER = e.

The RER is only a theoretical ideal. In practice, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. For example, if the price of a good increases 10% in the UK, and the Japanese currency simultaneously appreciates 10% against the UK currency, then the price of the good remains constant for someone in Japan. The people in the UK, however, would still have to deal with the 10% increase in domestic prices. It is also worth mentioning that government-enacted tariffs can affect the actual rate of exchange, helping to reduce price pressures. PPP appears to hold only in the long term (3–5 years) when prices eventually correct towards parity.

More recent approaches in modelling the RER employ a set of macroeconomic variables, such as relative productivity and the real interest rate differential.

Bilateral vs. effective exchange rate

Bilateral exchange rate involves a currency pair, while effective exchange rate is weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjust NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.

Uncovered interest rate parity

Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates increase while Japanese interest rates remain unchanged then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage. The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

UIRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency.

The uncovered interest rate parity postulates that

The equality assumes that the risk premium is zero, which is the case if investors are risk-neutral. If investors are not risk-neutral then the forward rate (F _{+ 1}) can differ from the expected future spot rate (E[S _{+ 1}]), and covered and uncovered interest rate parities cannot both hold.

The uncovered parity is not directly testable in the absence of market expectations of future exchange rates. Moreover, the above rather simple demonstration assumes no transaction cost, equal default risk over foreign and domestic currency denominated assets, perfect capital flow and no simultaneity induced by monetary authorities. Note also that it is possible to construct the UIP condition in real terms, which is more plausible.

Uncovered interest parity example

An example for the uncovered interest parity condition: Consider an initial situation, where interest rates in the home country (e.g. U.S.) and a foreign country (e.g. Japan) are equal. Except for exchange rate risk, investing in the US or Japan would yield the same return. If the dollar depreciates against the yen, an investment in Japan would become more profitable than a US-investment - in other words, for the same amount of yen, more dollars can be purchased. By investing in Japan and converting back to the dollar at the favorable exchange rate, the return from the investment in Japan, in the dollar terms, is higher than the return from the direct investment in the US. In order to persuade an investor to invest in the US nonetheless, the dollar interest rate would have to be higher than the yen interest rate by an amount equal to the devaluation (a 20% depreciation of the dollar implies a 20% rise in the dollar interest rate).

Technically however, a 20% depreciation in the dollar only results in an approximate rise of 20% in U.S. interest rates. The exact form is as follows: Change in spot rate (Yen/Dollar) equals the dollar interest rate minus the yen interest rate, with this expression being divided by one plus the yen interest rate.

Uncovered vs. covered interest parity example

Let's assume you wanted to pay for something in Yen in a month's time. There are several ways to do this.

• (a) Buy Yen forward 30 days to lock in the exchange rate. Then you may invest in dollars for 30 days until you must convert dollars to Yen in a month. This is called covering because you now have covered yourself and have no exchange rate risk.

• (b) Convert spot to Yen today. Invest in a Japanese bond (in Yen) for 30 days (or otherwise loan out Yen for 30 days) then pay your Yen obligation. Under this model, you are sure of the interest you will earn, so you may convert fewer dollars to Yen today, since the Yen will grow via interest. Notice how you have still covered your exchange risk, because you have simply converted to Yen immediately.

• (c) You could also invest the money in dollars and change it for Yen in a month.

According to the interest rate parity, you should get the same number of Yen in all methods. Methods (a) and (b) are covered while (c) is uncovered.

• In method (a) the higher (lower) interest rate in the US is offset by the forward discount (premium).
• In method (b) The higher (lower) interest rate in Japan is offset by the loss (gain) from converting spot instead of using a forward.
• Method (c) is uncovered, however, according to interest rate parity, the spot exchange rate in 30 days should become the same as the 30 day forward rate. Obviously there is exchange risk because you must see if this actually happens.

General Rules: If the forward rate is lower than what the interest rate parity indicates, the appropriate strategy would be: borrow Yen, convert to dollars at the spot rate, and lend dollars.

If the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be: borrow dollars, convert to Yen at the spot rate, and lend the Yen.Covered interest rate parity

Covered interest parity

(also called interest parity condition) means that the following equation holds:

where:

• is the domestic interest rate implied by debt of a given maturity;
• i_c is the interest rate in the foreign country for debt of the same maturity;
• S is the spot exchange rate, expressed as the price in domestic currency ($) of one unit of the foreign currency c, i.e. $/c;
• F is the forward exchange rate implied by a forward contract maturing at the same time as the domestic and foreign debt underlying and i_c. F is expressed in the same units as S, namely $/c.

Taking natural logs of both sides of the interest parity condition yields:

where all interest rates are now the continuously compounded equivalents. ln(F/S) is the forward premium, the percentage difference between the forward rate and the spot rate. Covered interest parity states that the difference between domestic and foreign interest rates equals the forward premium. When , the forward price of the foreign currency will be below the spot price. Conversely, if , the forward price of the foreign currency will exceed the spot price.

Covered interest parity assumes that debt instruments denominated in domestic and foreign currency are freely traded internationally (absence of capital controls), and have similar risk. If the parity condition does not hold, there exists an arbitrage opportunity. (see covered interest arbitrage and an example below).

The interest parity condition may also be expressed as:

The following common approximation is valid when S is not too volatile:

An example

In short, assume that

This would imply that one dollar invested in the US <>

The following rudimentary example demonstrates covered interest rate arbitrage (CIA). Consider the interest rate parity (IRP) equation,

Assume:

• the 12-month interest rate in US is 5%, per annum
• the 12-month interest rate in UK is 8%, per annum
• the current spot exchange rate is 1.5 $/£
• the forward exchange rate implied by a forward contract maturing 12 months in the future is 1.5 $/£.

Clearly, the UK has a higher interest rate than the US. Thus the basic idea of covered interest arbitrage is to borrow in the country with lower interest rate and invest in the country with higher interest rate. All else being equal this would help you make money riskless. Thus,

• Per the LHS of the interest rate parity equation above, a dollar invested in the US at the end of the 12-month period will be,

$1 · (1 + 5%) = $1.05

• Per the RHS of the interest rate parity equation above, a dollar invested in the UK (after conversion into £ and back into $ at the end of 12-months) at the end of the 12-month period will be,

$1 · (1.5/1.5)(1 + 8%) = $1.08

Thus one could carry out a covered interest rate (CIA) arbitrage as follows,

1. Borrow $1 from the US bank at 5% interest rate.
2. Convert $ into £ at current spot rate of 1.5$/£ giving 0.67£
3. Invest the 0.67£ in the UK for the 12 month period
4. Purchase a forward contract on the 1.5$/£ (i.e. cover your position against exchange rate fluctuations)

At the end of 12-months

1. 0.67£ becomes 0.67£(1 + 8%) = 0.72£
2. Convert the 0.72£ back to $ at 1.5$/£, giving $1.08
3. Pay off the initially borrowed amount of $1 to the US bank with 5% interest, i.e $1.05

The resulting arbitrage profit is $1.08 − $1.05 = $0.03 or 3 cents per dollar.

Obviously, arbitrage opportunities of this magnitude would vanish very quickly.

In the above example, some combination of the following would occur to reestablish Covered Interest Parity and extinguish the arbitrage opportunity:

• US interest rates will go up
• Forward exchange rates will go down
• Spot exchange rates will go up
• UK interest rates will go down