International Finance: Putting Theory Into Practice

176 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT

Figure 5.3:Spot/Forward/Money Market Diagram with bid-ask spreads

HCT FCT

HCt FCt

× 1. 2111 ×1.209

hcmoney market

× 1. 1011 ×1.099

fcmoney market

×109.98

× 1 / 110. 02

forward market

×99.99

× 1 / 100. 01.

spot market





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he or she will be able to finance the interim losses or invest the interim gains.
Second, the hedger does not know to what extent the forward rates will deviate
from the spot rates at the roll-over dates: these future forward premia depend on
the (unknown) future interest rates in both currencies. Third, the total cumulative
cash flow, realized by the hedger over the three consecutive contracts, depends on
the time path of the spot rates between time 1 and time 3.

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All this has given you enough background for a discussion of how and where forward
contracts are used in practice. Among the many uses to which forward contracts
may be put, the first we bring up is arbitrage, or at least the potential of arbitrage:
this keeps spot, forward and interest rates in line.

5.2 Using Forward Contracts (1): Arbitrage

One question to be answered is to what extent Interest Rate Parity still holds in the
presence of spreads. A useful first step in this analysis is to determine the synthetic
forward rates.