Empirical studies of the Treasury Bill markets have revealed substantial differences between the futures price and the implied forward price. These differences have been attributed to taxes, transaction costs, and the settling up procedure employed in the futures market. This paper examines the forward and futures prices in foreign exchange in an attempt to distinguish between the competing explanations.
EMPIRICAL STUDIES OF THETreasury bill market have revealed differences between the futures price (or rate) and the implicit forward price derived from the term structure of interest rates.1 These differences have generally been attributed to market "imperfections" such as taxes and transaction costs. (See, for example, Arak [1], Capozza and Cornell [2], and Rendelman and Carabini [6]). Recently, however, Cox, Ingersoll, and Ross [3], henceforth CIR, derived a model in which forward and futures prices need not be equal, even in perfect markets without taxes, as long as interest rates are stochastic.The significance of the CIR effect may be hard to investigate using only data from the bill market, because of the potentially complicating effects of taxes and transaction costs unique to this market. By using data from the foreign exchange market, we are able to eliminate the tax effect and reduce the impact of transaction costs. The question we address is whether the discrepancies observed in the Treasury Bill market are also observed in the foreign exchange market. If they are, then we have evidence that the differences are due to a combination of the CIR effect and the transaction costs common to both markets. If they are not, then either the magnitude of the CIR effect is much less in the foreign exchange market, or the Treasury Bill results are due to the unique tax treatment and transaction costs of that market. This paper is organized as follows. In Section I the trading mechanics of the forward and futures markets in foreign exchange are discussed. Section II reviews the explanations for the discrepancies between the forward and futures prices for Treasury Bills. The institutional differences between the foreign exchange and bill markets are also summarized to show which of these explanations cannot apply to the foreign exchange market. In Section III, the data are decribed and the empirical results are presented. The conclusions are summarized in the final section. * The authors would like to thank Michael Brennan, John Cox, and Jon Ingersoll as well as participants at finance workshops at UC Berkeley and UCLA for helpful comments. Research assistance was provided by Tom Hay. 'The papers include Capozza and Cornell [2], Lang and Rosche [5], Rendleman and Carbini [6], and Vignola and Dale [7].
