Take cover

THE most dangerous words in finance are: “This time is different.” But sometimes markets can genuinely change. After the 2007-08 financial crisis, markets are less efficient and liquid than before.

The evidence can be found in the currency markets, as a paper* in the latest quarterly bulletin from the Bank for International Settlements (BIS) explains. In foreign-exchange markets it is possible to buy currency at today’s rate (the spot market) or at some future point (the forward market). Any student of the currency markets will quickly come across the idea of “covered-interest parity”. This states that the gap between the spot price and the forward price will equal the interest-rate differential between the two countries.

Imagine that American 12-month interest rates are 10% and Japanese rates are 5%. Japanese investors will be tempted to buy dollars, earn interest on them for a year and then cover the exchange-rate risk through a forward deal. So lots of people will be selling dollars in the forward market. They will keep doing so until the dollar is 5% cheaper there than in the spot market, and there is no profit in the trade.

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This post was originally published in the Economist.

Take cover

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