192 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
ingredient action att action atT 1 (Apr) payoff at expiry
bet onFApr↑ buy forward Jun sell forward Jun [S ̃Apr+ ̃wApr-Jun]− 100. 7
hedgeSApr sell forward Apr buy spot 100. 3 −S ̃Apr
Combined: forward-forward spot-forward swap w ̃Apr-Jun−[100. 7 − 100 .3]
swap “out” “in” = ̃wApr-Jun−[0. 7 − 0 .3]We see that the ultimate profit is the realized swap rate in excess of the difference
of the original ones, 0.7 – 0.3 = 0.4.
An interesting reinterpretation is obtained if we look at the “actions” in the
Example’s table not row by row like we did thus far, but column by column (by
date, that is).
- Start with the future actions (those planned for April). What we will do in
April clearly is a spot-forward swap: we will buy spot and simultaneously sell
forward. (This is called a swap “in” because the transaction for the nearest
date, the spot one, takes us into thefc.) - What we do right now, att, is not unsimilar: we sell forward for one date
and simultaneously buy forward for another. This is called aforward-forward
swap, and this particular one is called “out” because the transaction for the
nearest date is a sale, which takes us out of thefc.
Thus, instead of saying that we bet on a rise in the April forward rate and hedge
the April spot component, we could equally well say that we now do a forward-
forward swap, April against June, and that on April 1 we reverse this with a spot-
forward swap.
5.5 Using Forward Contracts (4): Minimizing the Im-
pact of Market Imperfections
In the previous chapter we discovered that, in perfect markets, shopping around is
pointless: the two ways to achieve a given trip produce exactly the same output.
Among the imperfections that we introduce in this section are (a) bid-ask spreads,
(b) asymmetric taxes, (c) information asymmetries leading to inconsistent default-
risk spreads, and (d) legal restrictions. Each of them make the treasurer’s life far
more interesting than we might had surmised in the previous chapter.
5.5.1 Shopping Around to Minimize Transaction Costs
This type of problem is easily solved using the spot/forward/money-markets dia-
gram. A safe way to proceed is as follows:
- Identify your current position; this is where your trip starts;