his article aims to set forth guidelines for the design of successful spreads in T foreign exchange futures or forward contracts. A spread is a two-legged strategy which combines a purchase (sale) for a near maturity with an opposite sale (purchase)' for a distant maturity. Because spreads involve offsetting contracts, they are less risky than one-legged, open, or naked positions. They are not, however, riskless. The objective of this article, more narrowly stated, is to analyze the specific risks to which spreads in foreign exchange futures are exposed and to provide diagnostics for designing successful spreading strategies.
The discussion will be of interest not only to traders but to portfolio managers. A key problem in active international short-term cash management is that unhedged positions in foreign securities are exposed to the randomness of both interest rates and exchange rates, simultaneously. When either borrowing or purchasing a shortterm foreign currency bond or deposit, a good forecast of interest rates can readily be foiled by an adverse exchange rate movement and vice versa. Of course, each such position, if held to maturity, could be covered forward. Hedging, however, merely transforms a foreign currency amount into one denominated in dollars, and, together with the exchange risk exposure, hedging removes also the foreign interest-rate play. Spreads in forward contracts or futures contracts can, to be sure, be used to hedge pre-established but temporally mismatched commitments to buy and sell foreign currency in the future. Considered alone, however, spreads can further provide a useful addition to the portfolio manager's arsenal.
Specifically, spreads enable money managers to take advantage of credible interest-rate predictions while at the same time maintaining a high degree of protection against exchange risk. Conversely, spreads also permit investors to bet on exchange rate movements but with reduced exposure to unanticipated interest-rate variations. The focus is mainly on the first of these two opportunities, because it seems the more appealing in the context of managing internationally diversified cash positions.
The rest of this article is organized as fdlows. Section I shows that spreads are designed to exploit forecasts of the change in the difference between two prices.
iMichael Adler is Professor of Finance at the Graduate School of Business, Columbia University.