International Finance: Putting Theory Into Practice

4.2. THE RELATION BETWEEN EXCHANGE AND MONEY MARKETS 129

3. This futurenokoutcome is already being sold forward att; that is, right now
   you immediately cover or hedge thenokdeposit in the forward market so as
   to make its time-T value risk free rather than contingent on the time-T spot
   rate. The input for this transaction isNOKT= 1,100, and the output inclp
   at timeT will be 1, 100 ×110 = 121,000.

There is nothing difficult about this, except perhaps that by the time you finish
reading Step 3 you’ve already half forgotten the previous steps. We need a way to
make clear at one glance what this deal is about, how it relates to other deals and
what the alternatives are. One step in the right direction is to adopt a notation like

HCt= 100, 000

buy spot:

× 1 / 100

︷︸︸︷

→ FCt= 1, 000

deposit:

× (^1) ︷︸︸︷. 10
→ FCT= 1, 100
sell frwd:
× (^110) ︷︸︸︷
→ HCT= 121, 000
So the arrows show how you go from a spotclpposition into a spotnokone (the
spot deal), and so on. We can further improve upon this by arranging the amounts
in a diagram, where each kind of position has a fixed location. There are four kinds
of money in play: foreign and domestic, each coming in a day-tand a day-Tversion.
Let’s show these on a diagram, withhcon the left andfcon the right, and with
timeton top and timeTbelow. Figure 4.1 shows the result for the above example.
We can now generalize. Suppose the spot rate is stillclp/nok100, the four-year
forward rateclp/nok110, theclprisk-free is 21 percent effective, and thenok
one 10 percent. The diagram in Figure 4.2 summarises all transactions open to the
treasurer. It is to be read as follows:
Figure 4.1:Spot/Forward/Money Market Diagram: Example 4.6
HCT= 121, 000 FCT= 1, 100
HCt= 100, 000
START HERE
FCt= 1, 000

×1.10

× 110

× 1 / 100



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