Risks and Returns in International Currency Futures

G. N. NAIDU AND TAI S. SHIN*

Ever since the publication of Markowitz's groundbreaking article, much of the financial research has been concerned with the studies of risk and return characteristics of investments. In modern capital market theory, an investment is analyzed on the basis of risk and return re- gardless of the fact whether the investment is a common stock, preferred stock, bond or a real asset. The theory asserts that the returns must be proportional to the risk level in a well-func- tioning market. While much of the prior research has been focused on risk and return of security investments, this paper analyzes the risk and re- turn characteristics of currency futures traded on International Monetary Market of Chicago.

Trading in future contracts for foreign cur- rencies began on the International Monetary Market (I.M.M.) of Chicago on May 16, 1972. The British pound, Mexican peso, Canadian dol- lar, German mark, Swiss franc, Italian lira and Japanese yen are currently traded on the ex- change. This organized futures market in foreign currencies attracts diverse participants. The market participants are bankers, importers, ex- porters, multinational corporations and private speculators. The growing popularity of IAI.M. is reflected in its explosive spurt in trading vol- ume and soaring prices of its membership seats. The number of contracts traded on I.M.M. surged fivefold in 1977 alone.

This paper attempts to quantify the rates of return for currency futures traders and the ex- tent of risks they are exposed to. This quantifi- cation helps us to identify the precise nature of the relationship between risk and return in fu- tures markets.

*Illinois State University and Virginia Common- wealth University, respectively.

Naidu and Shin [1977], in an earlier study, demonstrated that the traders of foreign cur- rency futures could have realized above-normal profits using mechanical trading rules. Although those results may imply that the foreign cur- rency futures market is less efficient than ex- pected, one must reserve judgment until the risk dimension of the currency futures is fully ex- plored. Thus, the purpose of this study is to determine whether or not the returns are com- mensurate with the risk level in international currency futures market.

Risk and Return in Futures Markets

A currency futures contract is an agreement to buy and receive or to sell and deliver a quan- tity of a specified currency at a future date. The exchange rate that will be in effect at that future date, for the purpose of the future con- tract, is determined at the time of contract acceptance. This "contract price" or futures price is binding on both parties to the agree- ment. The organized exchange in Chicago in futures offers another avenue for multinational corporations and foreign exchange departments of commercial banks to hedge their foreign ex- change risk.

Ascertaining risk-return relation of invest- ments requires the definition of appropriate in- vestment and its rate of return. Identifying the capital investment in securities trading is fairly easy. In futures trading, however, defining ap- propriate capital investment is rather contro- versial. Since virtually all futures contracts are bought and sold short on margins that typically range from 5 to 10 percent of the face value of the contract, one may treat the margin amount as the trader's capital investment.

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Shrock [1971, pp. 270-93] and Panton and Joy [1979, pp. 73-86] used margin amount as the base in calculating the rates of return to fu- tures speculators. This procedure, although ap- pealing on the surface, breaks down as one traces the subsequent history of the payment that is turned over to the broker. Unlike other capital assets such as common stocks where the margin is transferred from buyer to seller, the margin on a futures contract is kept in an es- crow by the broker. Not only does the seller of the futures contract not receive the margin transfer, but he/she actually has to deposit an equivalent amount of margin with the broker. When the account is closed out, the broker re- turns the escrowed margin plus or minus any profits or losses (net of commissions in the case of profits and inclusive of commissions in the event of losses) that occurred over the hold- ing period, Dusak [1973, p. 1391].

Furthermore, some brokers allow the use of interest-earning cash equivalents (usually U.S. Treasury bills) as margin for accounts with equity greater than a specified minimum. If interest-earning securities are posted to meet margin requirements, it is clear that no invest- ment is involved in an open position.

For these reasons, Dusak [1973] argued that the margin money cannot be treated as a port- folio asset in the market equilibrium framework. Under market equilibrium, the percentage change in futures' price can serve as a measure of risk premium. However, one cannot interpret this percentage change as rate of return in Mark- owitz sense since the holder invests no current resources in the contract.

It appears that Keynes and his followers identify the risk of a future's contract with its price variability, Keynes [1930, p. 144]. Markowitz also used re turn variability as a measure of investment risk. Modern capital market theory says that total variability con- sists of two components-market or systematic risk and nonmarket risk. Since the nonmarket risk can be diversified away through the con-

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struction of efficient portfolios, the investor in an efficient market will not be compensated for bearing this diversifiable portion of the risk; investors are compensated only for bearing the systematic risk. Accordingly, in a rational in- vestor world, Sharpe [1964, pp. 425-42] and Lintner [1965, pp. 587-615] advocate that the relevant measure of an investment's risk is its systematic risk.

Data and Methodology

Weekly data on closing prices were collected for the futures contracts of British pound, Deutsche mark, and Japanese yen traded on IMM since May, 1972, from the IMM's Year Books. Closing values of Standard & Poor's index of 500 common stocks were gathered for every week over the period 1972-77. Weekly holding period rates of return were computed for this S & P index and used as proxy for the market rate of return, Rmt to estimate syste- matic risk of currency futures.

Comparable rates of return were computed for futures contracts in British pound, Deutsche mark and Japanese yen since the initiation of their trading. The estimates of systematic risk are obtained from the time series regression of the Market Model

where

Rmt

= holding period return of i th contract during week t

= holding period return on the market portfolio such as S & P index during week t

e"t = error term such that E ( ~ ) = 0.

In addition, the characteristics of return distri- butions were analyzed. These results are pre- sented in Table 1 and Table 2.

Discussion of Results

Table 1 shows the beta values measured rela-

NAIDU AND SHIN: INTERNATIONAL CURRENCY FUTURES

tive to Standard & Poor's 500 - stock index for British pound, German mark and Japanese yen futures. All the beta values except that for Sep- tember yen are close to zero, indicating that there was very little correlation between cur- rency returns and stock returns during the period covered (1972-77).

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weekly risk premium was not significantly dif- ferent from zero implying that the speculators in these currency futures, on balance, have not earned excess risk premiums.

To that extent one may conclude that the currency futures market is an efficient price generating system. However, the returns/risk

TABLE 1

RISKS IN CURRENCY FUTURES 1972 - 1977

Future Contract Estimate S.E. of t-Value Significance of Beta Estimate Level

British Pound:

March -0 .0430 0.036 - 1.19 0.2341 June -0 .0029 0.030 -0 .10 0.9224 Sept. -0 .0250 0.045 -0.55 0.5820 Dec. - 0.0009 0.030 - 0.03 0.9749

Deutsche Mark:

March 0.0519 0.044 1.18 0.2405 June -0 .0379 0.032 - 1.16 0.2461 Sept. -0 .0414 0.035 - 1.20 0.2329 Dec. 0.0487 0.034 1.44 0.1521

Japanese Yen:

March 0.0135 0.039 0.34 0.7307 June -0.0658 0.040 - 1.66 0.0991 Sept. 0.0924 0.035 2.61 0.0097 Dec. 0.0029 0.044 0.07 0.9467

One may note from Table 2, however, the total variability of returns/risk premiums ranges from 1.2 percent to 1.8 percent per week. Given that the systematic risk of these currency fu- tures is zero or negligible, we should expect no significant risk premiums for the futures con- tracts according to capital asset pricing theory. It may be seen in Table 2 that the average, ex- post, risk premium per week varies from -0.003 percent to +0.005 percent. The standard error of the mean, however, is large enough not to reject Ho: x = 0. In other words, the average

premiums computed in this study apply only to the holders of long sides in these futures. Some speculators may be staying on the short side of the market. This paper has not explicit- ly investigated the short positions. However, since the futures market is a zero-sum game, except for transaction costs, we can infer from our results that the average risk premium for short sellers is also close to zero.

If the traders in currency futures are not earning above average returns, why did the market experience such phenomenal growth

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TABLE 2

CURRENCY FUTURES RETURN DISTRIBUTIONS 1972 - 1977

Currency Future Mean Standard S.E. Skewness Kurtosis Deviation

British Pound:

March -0.0002 0.014 0.001 0.576 27.248 June -0.0010 0.012 0.001 -0.288 2.242 Sept. -0.0003 0.018 0.001 1.433 46.769 Dec. -0.0010 0.012 0.001 0.044 2.507

Deutsche Mark:

March 0.0010 0.017 0.001 2.120 14.482 June 0.0005 0.013 0.001 1.341 7.747 Sept. 0.00004 0.014 0.001 0.549 4.908 Dec. 0.0001 0.014 0.001 0.884 6.488

Japanese Yen:

March 0.0010 0.015 0.001 0.681 8.336 June 0.0010 0.014 0.001 0.890 6.914 Sept. -0.0003 0.013 0.001 -0.292 6.458 Dec. -0.0010 0.0!7 0.001 1.400 19.585

over the past six years? Several explanations are in order. First, currency futures trading serves an important function for the multi- national companies and foreign exchange de- partments of commercial banks to help reduce their exposure to foreign exchange risk. Conse- quently, these institutions seem to be partici- pating increasingly in this market to hedge their foreign exchange risks.

Secondly, even if the average risk premium is close to zero, it doesn't mean a zero risk premium in all transactions. A glance at the skewness parameter in Table 2 reveals that most of these currency futures have positively skewed return distributions. When return dis- tribution is skewed to the right, investors have a small chance for a large gain. Investors, es- pecially those with speculative desire, seem to prefer skewness in return distributions. Kraus

and Litzenberger [1976, pp. 1085-100] con- sider skewness and systematic risk to be the two important determinants of security's risk premium. The same two risk parameters also seem to determine the level of risk premium in currency futures.

Finally, there is a portfolio theoretic ex- planation for the existence of investor pref- erence for an asset with zero risk-premium and zero systematic risk. Markowitz, in his pioneering work, pointed out that one must add an asset to the existing portfolio if that addition can reduce the risk level of the entire portfolio. Such a risk reduction can be achieved, however, only if the newly added asset's returns are less than perfectly positively correlated with the existin~ portfolio returns.

The fact tht the beta value for currency futures is close to zero implies that the currency

NAIDU AND SHIN: INTERNATIONAL CURRENCY FUTURES 79

futures' returns are uncorrelated with the mar- ket portfolio. Therefore, investors can reduce the risk level of their entire wealth portfolio by adding the currency futures. This may be done even if the average risk premium is zero on the futures contract. It is not all that clear as to how many investors are actually using cur- rency futures just to reduce their portfolio risk through diversification. Nevertheless, the po- tential for doing so appears to be great.

Compariosn with Previous Studies

The amount and nature of returns earned by speculators in futures markets have generated considerable controversy over the years. At one extreme, J. M. Keynes [1930] says that the speculators in futures markets underwrite the risks of price fluctuations of the spot com- modity. For this service, the hedger or the in- sured is expected to pay a premium to the speculator or the insurer. At the other extreme, C. O. Hardy [1940] argues that the speculators are essentially gamblers and they are willing to pay for the privilege of gambling in a socially acceptable form.

In addition to these two views, we have a more general theory known as capital market theory. The capital market theory, by itself, makes no presumption as to whether returns to speculators are positive, as Keynes hypothesized, or zeroish to negative, as Hardy believed. It says, rather, that the required rate of return on any risky asset, including futures market assets, is determined by that asset's contribution to the risk of a large and well-diversified portfolio of assets.

In an attempt to resolve the longstanding controversy whether speculators in a futures market earn a risk premium, Dusak [1973, pp. 1387-406] applied modern capital market theory to a group of commodity futures con- tracts. The systematic risk was estimated for a sample of wheat, corn and soybean futures con- tracts over the period. 1952-67. All the beta values were found to be close to zero. Further-

more, the average holding period return on the contracts over the same period was also zero. The evidence presented by Dusak conformed better to the capital asset pricing theory than to Keynsian speculative market model. The results of our study concur with those of Dusak and thus broaden the evidence for her earlier con- clusion.

The results presented in this paper also con- cur with the results obtained by Panton and Joy [1979]. Panton and Joy tested interest rate parity theory on IMM currency futures. As a part of the investigation, they also assessed the size of returns possible in this futures market. Returns were estimated for holding periods of one quarter, two quarters, three quarters and a year. Surprisingly, the average holding period rate of return was not significantly different from zero.

Although our results coincide with those of Panton and Joy, a methodological difference and its effect must not escape without a men- tion. Panton and Joy used the margin amount as the base in computing the rate of return. The reader may recall our objection to this procedure earlier in the paper. Once the margin is treated as investment, the currency futures become "highly levered" and extremely risky investments. Taking the required marNn as in- vestment base, they certainly are risky, but there is no more need for an investor to main- tain such high leverage than there is to buy stocks on margin. The percentage change in the value of a contract over a relatively short hold- ing period is, in fact, likely to be smaller than that of a typical common stock.

Our study found that, judged by variation in market price, a currency future contract is con- siderably less risky than Standard & Poor's 500

stock index. However, Panton and Joy's re- sults may lead us to believe otherwise since the high degree of leverage used in their calcula- tions is bound to increase substantially the volatility of holding period returns. Panton and Joy, however, did not estimate beta values, per-

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haps, because it was not the main intention of their paper.

Conclusion

This paper analyzed the risk/return level of

international currency futures traded on Inter-

national Monetary Market of Chicago during

1972-1977 period. The empirical results indi-

cate that relative risk and returns for each cur-

rency future studied are both close to zero during the sample period. The fact that the

beta value for currency futures is close to zero

implies its returns are uncorrelated with the market portfolio. Therefore, investors can re- duce the risk level of their total portfolio sig- nificantly by adding currency futures.

REFERENCES

Katherine Dusak, "Futures Trading and Investor Returns: An Investigation of Commodity Market Risk Premiums," Journal of Political Economy, November/ December 1973, pp. 1387-406.

Charles O. Hardy, Risk andRisk Bearing, Chicago: University of Chicago Press, 1940.

John M. Keynes, A Treatise on Money, Vol. 2, London: Macmillan, 1930.

John Lintner, "Security Prices, Risk, and Maxi- mal Gains from Diversification," Journal of Finance, December 1965, pp. 587-615.

G. N. Naidu and Tai Shin, "International Cur- rency Futures: A Test of Market Efficiency," Paper presented in AIB Meeting, Orlando, August 1977.

William Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk," Journal of Finance, September 1964, pp. 425-42.

Alan Kraus and Robert Litzenberger, "Skewness Preference and Valuation of Risky Assets," Journal of Finance, September 1976, pp. 1085-100.

Don Panton and Maurice Joy, "Empirical Evidence on International Monetary Market Currency Futures," Commodity Markets and Futures Prices, Chicago Mer- cantile Exchange, 1979, pp. 73-86.

Nichols Schrock, "The Theory of Asset Choice: Simultaneous Holdings of Short and Long Positions in the Futures Markets," Journal of PoliticaIEconomy, March/April 1971, pp. 270-93.