The new world of forward FX prices -less liquidity

The dollar has been one of the few assets which have shown strength. Of course, the European would think differently with their falling euro. Yet, the credit debacle has problems on the most liquid market in the world. This is due not the lack of credit to trade FX but associated with the pricing of forward which are tied to banks funding costs.

We watch spreads in the forward market very closely and have seen a significant increase in spreads and volatility which far exceeds the volatility in the spot market. Obviously, the volatility in the forward market is a combination of three things, the volatility of spot, interest differentials and the covariance between the two. The increase in interest differentials have not been offset by the covariance.

If fact, forward prices have become more jagged as short rate funding problems have carried over to pricing in ways that have not been seen in longer dates pricing. In fact, we would say that some of the dollar rally on certain days is associated with the high rates in the US relative to Europe even though the target rates in Europe are higher. These flows actually will change intraday as the Fed funds market clears. Even the most liquid markets in the world are seeing the effects of the credit crisis.