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Politics : Ask Michael Burke

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To: S. maltophilia who wrote (65928)	8/6/1999 9:10:00 PM
From: Henry Volquardsen	Read Replies (1) of 132070

Khalil the Di-Tech weasel LOL evrytime I see that commercial I want to throw a brick at the tv. <<forward start sterling vs euro convergence trade>> Let's pretend I'm, say, the Orange County treasurer. Can you explain this to me?- so real simple right? <g> A forward rate is the rate you can enforce for some specific future period. The classic example is if you were trying to lock up financing for a future project. Lets say you want to plan a project that is going to start in a year and you will need funding for a year. You are concerned that rates will rise and want to lock in the rate. Assuming you have no derivatives how would you enforce this rate? You could borrow the money today at a fixed rate for two years and then invest it for a year. If two year rates are 6% and one year rates are 5% what is the one year rate one year forward? On a $100 the cost to borrow for two years is $6 per year for a total of $12. If you invest the $100 for the first year you will get $5. $12 less $5 gives you a net cost of $7. So the one year rate one year forward is 7%. This is the simple answer. The precise answer takes into account compounding and financing of the coupons. But this is accurate enough for explanation. Eurodollar futures are all forward rates. Forward rates can be calculated for all sorts of combinations of periods. Sometimes they can show some interesting anomalies in the curve. Swap dealers are very sensitive to these forward rates. Swap dealers have always positioned forward rates. In recent years it has become very popular among hedge funds as well. It is particularly popular for expressing convergence trades. The particular trade I mentioned is pretty straight forward. The 5 year sterling rate starting 5 years forward was @100 basis points lower than the 5 year euro rate starting in 5 years. There are a number of people who believe sterling will join the euro within 5 years. If that happens the rates will converge. To express this view they put on a trade where they borrow sterling in 5 years for 5years and lend euro in 5 years for 5 years. If sterling enters you will earn the 100 basis point. Unfortunately for people who put on this type of trade forward rates can be volatile and often trade in a quirky fashion. The spread has continued to widen and they are under water. I hope this helps. Let me know if it doesn't. Henry

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