NEW YORK ( TheStreet) -- The Wall Street Journal misunderstood the nature of some currency ETFs in a story last week that compared the WisdomTree Dreyfus Chinese Yuan Fund ( CYB) with U.S. Natural Gas ( UNG). The article concluded that a buyer of CYB may not realize the gain in the Chinese yuan because speculators have already bid up the price of yuan forward contracts. When UNG rolled its contracts this summer, it paid a steep premium between the contract it was holding and the near-month contract it wanted to buy. Each time UNG sold, it depressed the price of the contract it was selling and increased the price of the contract it bought. Other factors contributed to a situation whereby the spot price of natural gas was much lower than the contract prices for futures further out in time. In the case of CYB, the premium it pays is not due to the fact that it rolls its contracts monthly, but rather that traders believe the Chinese currency will appreciate. CYB is not losing money every time it rolls the way UNG did. There is a premium in the currency market for yuan. A commodities trader could purchase a 2010 futures contract and mitigate contango (while taking on other risks), but a currency trader cannot escape the premium for yuan. In any event, it is incorrect to think of currency forwards in the same way as commodity futures. There isn't contango (when the near-month contract costs more than the current contract), nor backwardization (when the near-month contracts are cheaper). Most often, the difference in the contract prices is a result of the implied rate, or the interest-rate differential between the two currencies.
There is also the factor of speculative demand. If traders expect a currency will appreciate, they will bid up the price of the forward contracts. In some cases, they may be willing to pay a hefty premium for the chance of further gains, but with the Chinese yuan, the premium right now is small. Importantly, the fund is up 1.8% this year, compared to less than 1% for the underlying currency. The fund captured the gain in the yuan, and more. In the Journal article, the author compares this premium as similar to the contango in UNG, but there are big differences with UNG and other commodity futures ETFs. In the case of commodities, higher prices in the future are based on the cost of storing the commodity and the opportunity cost of foregone interest on cash, along with speculative demand. UNG also had problems specific to itself and the natural gas market. First, it became the market. It owned so much of the outstanding contracts that it had to move into swaps. Its size in the market meant that traders could exploit its strategy and front-run the fund, and this exacerbated contango. CYB is a relatively popular currency fund, but its $150 million in assets is a very small portion of a huge market. Second, storage issues caused the near-month gas prices to plummet, compared to much more stable prices further out in time. In the case of currencies, they aren't physical and suffer no similar problem.
In conclusion, the premium in CYB is entirely driven by market expectations, while UNG was the victim of market failures. An individual can avoid the problems of UNG by doing their homework and purchasing futures contracts for their own account using a different strategy. In the case of Chinese yuan forward contracts, an individual investor would be in the same position as the Wisdom Tree ETF. The biggest difference between the prices of forward contracts further out in time is based on interest rates. Since interest compounds, longer-dated contract have a larger interest component than near-term contracts. Tuesday, I'll explain how interest rates affect forward prices and get into greater detail on currency ETFs. -- Written by Don Dion in Williamstown, Mass.