4.2. THE RELATION BETWEEN EXCHANGE AND MONEY MARKETS 131
The General Spot/Forward/Money Market Diagram
To use the diagram, first identify the starting position. This is where you have
money right now—likeFCT(: a customer will pay youfcin future, or a deposit
will expire). Then determine the desired end point, likeHCT (: you want future
hcinstead; that is, you want to eliminate the exchange risk). Third, determine by
which route you want to go fromSTARTtoEND. Lastly, follow the chosen route,
sequentially multiplying the starting amount by all the numbers you see along the
path.
Example 4.7
In Example 4.6, the path isHCt →FCt→FCT →HCT, and the end outcome,
starting fromHCt= 100,000 is immediately computed as
HCT= 100, 000 ×1
100
× 1. 10 ×110 = 121, 000. (4.5)
The alert reader will already have noted that this is a synthetichc deposit,
constructed out of afcdeposit and a swap, and that (here) it has exactly the same
return as the direct solution. Indeed, the alternative route,HCt →HCT, yields
100 , 000 × 1 .21 = 121,000. (Inimperfect markets this equivalence of both paths will
no longer be generally true, as we shall see in the next chapter.)
Example 4.8
Suppose that a customer of yours will paynok6.5m at time T, four years from
now, but you need cash Pesos to pay your suppliers and workers. You decide to
sell forward, and take out aclploan with a time-T value that, including interest,
exactly matches the proceeds of the forward sale. How much can you borrow on the
basis of this invoice without taking any exchange risk?
The path chosen isFCT(=nok 6 , 500 ,000)→HCT→HCt, and it yields6. 5 m× 110 ×1
1. 21
=clp 590 , 909 , 090. 91. (4.6)The clever reader will again eagerly point out that there is an alternative: borrow
nokagainst the future inflow (that is, borrow such that the loancuminterest is
serviced by thenokinflow), and convert the proceeds of the loan intoclp. Again,
in our assumedly perfect market, the outcome is identical: 6. 5 m/ 1. 10 ×100 =
clp 590 , 909 , 090 .91. Thus, the diagram allows us to quickly understand the purpose,
and see the outcome of, a sequence of transactions. It also shows there are always
two routes that lead from a given starting point to a given end point—a useful
insight for shopping-around purposes. The advantage of using the diagram will be