4.5. CFO’S SUMMARY 151
other activities. We return to this in Chapter 12.
4.5 CFO’s Summary
In this chapter, we have analyzed forward contracts in a perfect market. We have
discovered that forward contracts are essentially packaged deals, that is, transactions
that are equivalent to a combination of a loan in one currency, a spot transaction,
and a deposit in the other currency. In this sense, the forward contract is a distant
forerunner of financial engineering. We have also seen how exchange markets and
money markets are interlinked and can be used for arbitrage transactions and for
identifying & comparing the two ways to make a particular transaction.
In perfect markets, it does not matter whether one uses forward contracts as
opposed to their money-market replications. This holds for any possible transaction
and its replication. For instance, a German firm will neither win nor lose if it
replaces aeurdeposit by a swappedusddeposit since, from Interest Rate Parity,
the two are equivalent. Or, more precisely,if it matters, it’s because of market
imperfections like spreads, or because the firm’s other cash flows are affected too,
but not because of the pure exchange of afccash flow by one inhc. We turn to
market imperfections in the next chapter, and to the relevance of hedging in Chapter
12.
We have also found that the value of a forward contract is zero. This means that,
everything else being the same, our German firm will not win or lose if it replaces a
eurdeposit by anuncoveredusddeposit. Again, a big word of caution is in order,
here, because the “everything else being the same” clause is crucial. The above
statement is perfectly true about the purePVof two isolated cash flows, one ineur
and one inusd. But if the firm is so levered, theusddeposit is so large, and the
eur/usdso volatile that the investment could send the firm into receivership, then
the dollar deposit would still not be a good idea—not because of the depositper se,
but because of the repercussions it could have on the firm’s legal fees and interest
costs and asset values. In short, the deposit’s cash flows can have interactions with
the company’s other business, and these interactions might affect the firm’s value.
A last crucial insight is that the forward rate is the market certainty equivalent,
that is, the market’s expectation corrected for any risks it thinks to be relevant. This
insight can save a company a lot of time. It is also fundamental for the purpose
of asset pricing. For cashflows with a knownfccomponent, the logic is of course
straightforward: (a) an asset with a knownfcflowCT∗is easy to hedge: sell forward
CT∗ units offc; (b) the hedged asset is easy to value; (CT∗×Ft,T)/(1 +rt,T); and
(c) the unhedged asset must have the same value because the hedge itself has zero
initial value and because a risk-freefcamountC∗Tcannot be affected by the hedge.
Interestingly, under some distributional assumptions we can also apply the logic
to cashflows that are highly non-linear functions of the future exchange rate. We
return to this issue in Chapter 9.