[PairTheBoard]

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If the market knew for a fact that China was going to unpeg the Yuan in say 11 months but keep it pegged right now you can bet your house that so much money would flow into Yuan futures that all the arbitrage in the world would not hold the price down. People would still certainly borrow dollars to buy Yuan right now. But they wouldn't waste their Yuan on little premiums selling USD/CNY futures contracts barely above current spot prices. They would just hold the Yuan for 11 months.

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whats funny here is that i re-read my posts and one of the conditions for the spot-futures relationship wasn't mentioned. namely, the spot price has to be free to move.

in the example you gave, china could keep their currency pegged for those 11 months (albeit with increasingly large costs since everybody would be clamoring for yuan) and the futures price would increase significantly b/c the spot price cannot move despite all the buying.

you are also correct that PBOC is providing the free money here (which goes back to why i think currency markets present some of the biggest opportunities and can be very inefficient) since they are basically the only ones willing to sell yuan.

in all smoothly traded futures markets though (where both sides are free to move and you can long/short both spot and futures), the prices are tied together via arbitrage.

Barron

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Right. China's artificial peg, paying too many Yuan for dollars on the spot market, creates an artificial spread between the spot and futures market that would normally be arbed away in a free spot market. The market knows China can't keep doing that forever. Sometime in the future the Yuan must adjust up.

One thing to keep in mind is that the higher inflation gets in China the less attractive these Yuan plays become. If China inflation stayed high enough, long enough, the underlying - and unknown due to lack of a free spot market - value of the Yuan would be slowly declining in the background against the dollar. In that case China could concievably continue its peg indefinitely until the real value of the Yuan actually came into line with the peg. All those people who borrowed dollars to buy and hold Yuan would lose the interest rate differential over the time of their play. And all those who bought Yuan futures at premiums would lose the premiums they paid, including that part of the premium based on the interest rate differential.

Be careful. China may have a better idea what it's doing than we think. At the end of the day China controls the spigots to the Yuan.


PairTheBoard