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International Finance FIN 456 ♦ Fall 2012 Michael Dimond International Finance FIN 456 ♦ Fall 2012 Michael Dimond

Some Basic Interest Rates • • • US Risk-free rate: The yield on US Some Basic Interest Rates • • • US Risk-free rate: The yield on US Government bonds, set at auction. This is considered to be the highest return a US investor could get with zero default risk and is the basis for computing appropriate return on riskier assets. Federal Overnight Funds Rate: The target interest rate set by the Federal Open-Market Committee (FOMC) for overnight lending and borrowing transactions between US banks set by the Federal Open-Market Committee (FOMC). LIBOR: Average of the rates UK banks claim to be able to borrow from one another. LIBOR is a floating rate. Established in the 1980 s in UK. This rate gets quoted based on the expected duration of the loan (LIBOR 3 is the 3 -month rate, LIBOR 6 is the 12 -month rate). Prime Rate: This is the average base rate posted by the largest US banks. Fixed rate, but updated frequently (when 7/10 of the largest banks change). Since 1991, Prime has usually been approximately the Fed Rate + 3%. Both LIBOR & Prime are used as a basis for commercial interest rates. For example, one might be able to borrow for six months at Prime+1, or at LIBOR 6+4 • • If Prime = 3. 25%, one could borrow at 4. 25% (Prime+1) If LIBOR 6 = 0. 46%, one could borrow at 4. 46% (LIBOR 6+4) Michael Dimond School of Business Administration

Michael Dimond School of Business Administration Michael Dimond School of Business Administration

Michael Dimond School of Business Administration Michael Dimond School of Business Administration

Michael Dimond School of Business Administration Michael Dimond School of Business Administration

Interest Rate Risk • Ever increasing competition has forced financial managers to better manage Interest Rate Risk • Ever increasing competition has forced financial managers to better manage both sides of the balance sheet • All firms, domestic or multinational, are sensitive to interest rate movements • The single largest interest rate risk of a non-financial firm is debt service (for an MNC, differing currencies have differing interest rates thus making this risk a larger concern) • The second most prevalent source of interest rate risk is its holding of interest sensitive securities • Can these rates be manipulated? http: //www. ft. com/indepth/libor-scandal Michael Dimond School of Business Administration

International Interest Rate Calculations Michael Dimond School of Business Administration International Interest Rate Calculations Michael Dimond School of Business Administration

Summary of Option Premium Components Michael Dimond School of Business Administration Summary of Option Premium Components Michael Dimond School of Business Administration

MNC Foreign Investments • Financing vehicles include: • • Interest rate swaps Currency swaps MNC Foreign Investments • Financing vehicles include: • • Interest rate swaps Currency swaps Structured notes Interest rate forward contracts Interest rate futures contracts International leasing LDC debt-equity swaps • Strategic Goals • • Reduce cost to service debt Reduce tax burden Mitigate political risk Mitigate foreign exchange risk Michael Dimond School of Business Administration

Credit and Repricing Risk • Credit Risk or roll-over risk is the possibility that Credit and Repricing Risk • Credit Risk or roll-over risk is the possibility that a borrower’s creditworthiness at the time of renewing a credit, is reclassified by the lender – This can result in higher borrowing rates, fees, or even denial • Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is being reset • Three strategies a corporate borrower might employ to borrow $1 MM for 3 years: 1. Borrow dollars for 3 years at fixed interest (Prime + premium) 2. Borrow dollars for 3 years at a floating rate (LIBOR + premium), to be reset annually 3. Borrow dollars for 1 year at a fixed rate, then renew credit annually Michael Dimond School of Business Administration

Credit and Repricing Risk • Strategy #1 (3 yr Fixed) assures itself of funding Credit and Repricing Risk • Strategy #1 (3 yr Fixed) assures itself of funding at a known rate for the three years; what is sacrificed is the ability to enjoy a lower interest rate should rates fall over the time period • Strategy #2 (3 yr Floating) offers what #1 didn’t, flexibility (repricing risk). It too assures funding for the three years but offers repricing risk when LIBOR changes • Strategy #3 (1 yr Fixed w/ Annual Re. Fi) offers more flexibility and more risk; in the second year the firm faces repricing and credit risk, thus the funds are not guaranteed for the three years and neither is the price Michael Dimond School of Business Administration

Interest Rate Futures • Interest Rate futures are widely used; their popularity stems from Interest Rate Futures • Interest Rate futures are widely used; their popularity stems from high liquidity of interest rate futures markets, simplicity in use, and the rather standardized interest rate exposures firms posses • Traded on an exchange; two most common are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) • The yield is calculated from the settlement price – Example: March ’ 03 contract with settlement price of 94. 76 gives an annual yield of 5. 24% (100 – 94. 76) Michael Dimond School of Business Administration

Eurodollar Futures Prices Michael Dimond School of Business Administration Eurodollar Futures Prices Michael Dimond School of Business Administration

Interest Rate Futures Strategies Michael Dimond School of Business Administration Interest Rate Futures Strategies Michael Dimond School of Business Administration

Interest Swaps & Currency Swaps • Swaps: financial transactions in which two counterparties agree Interest Swaps & Currency Swaps • Swaps: financial transactions in which two counterparties agree to exchange streams of payments over time • • A package of forward contracts. For swaps to provide a real economic benefit to both parties, a barrier generally must exist to prevent arbitrage from functioning fully, such as: • • Legal restrictions on spot and forward foreign exchange transactions Different perceptions by investors of risk and creditworthiness of the two parties Appeal or acceptability of one borrower to a certain class of investor Tax differentials Michael Dimond School of Business Administration

Interest Rate Swaps • Swaps are contractual agreements to exchange or swap a series Interest Rate Swaps • Swaps are contractual agreements to exchange or swap a series of cash flows • If the agreement is for one party to swap its fixed interest payment for a floating rate payment, its is termed an interest rate swap • If the agreement is to swap currencies of debt service it is termed a currency swap • A single swap may combine elements of both interest rate and currency swap • The swap itself is not a source of capital but an alteration of the cash flows associated with payment Michael Dimond School of Business Administration

Interest Rate Swaps • If firm thought that rates would rise it would enter Interest Rate Swaps • If firm thought that rates would rise it would enter into a swap agreement to pay fixed and receive floating in order to protect it from rising debt-service payments • If firm thought that rates would fall it would enter into a swap agreement to pay floating and receive fixed in order to take advantage of lower debt-service payments • The cash flows of an interest rate swap are interest rates applied to a set amount of capital, no principal is swapped only the coupon payments Michael Dimond School of Business Administration

Interest Rate Swap Strategies Michael Dimond School of Business Administration Interest Rate Swap Strategies Michael Dimond School of Business Administration

Currency Swaps • Since all swap rates are derived from the yield curve in Currency Swaps • Since all swap rates are derived from the yield curve in each major currency, the fixed-to floating-rate interest rate swap existing in each currency allows firms to swap across currencies. • These swap rates are based on the government security yields in each of the individual currency markets, plus a credit spread applicable to investment grade borrowers in the respective markets. • The utility of the currency swap market to a MNC is significant. A MNC wishing to swap a 10 -year fixed 6. 04% U. S. dollar cash flow stream could swap to 4. 46% fixed in euro, 3. 30% fixed in Swiss francs, or 2. 07% fixed in Japanese yen. It could swap from fixed dollars not only to fixed rates, but also to floating LIBOR rates in the various currencies as well. Michael Dimond School of Business Administration

Interest Rate and Currency Swap Quotes Michael Dimond School of Business Administration Interest Rate and Currency Swap Quotes Michael Dimond School of Business Administration

Classic Interest Swap Can borrow at L+0. 5% or 8. 5% Can borrow at Classic Interest Swap Can borrow at L+0. 5% or 8. 5% Can borrow at L+0. 0% or 7. 0% Kept 10 bps Saved 65 bps Savings Available 8. 5% L+0. 5% 7. 0% L+0. 0% -----------1. 5% 0. 5% 1. 5% -0. 5% -----1. 0% 100 bps Saved 25 bps Michael Dimond School of Business Administration

Fixed for Fixed Currency Swap Michael Dimond School of Business Administration Fixed for Fixed Currency Swap Michael Dimond School of Business Administration

Fixed for Fixed Example • Suppose Dell wants to borrow £ 10 million for Fixed for Fixed Example • Suppose Dell wants to borrow £ 10 million for two years and Virgin Airlines wants to borrow $16 million for two years, and the current ($/£) exchange rate is $1. 60. Because Dell is better known in the United States, it can borrow on its own dollars at 7 percent and pounds at 9 percent, whereas Virgin can on its own borrow dollars at 8 percent and pounds at 8. 5% a) b) c) d) What swap transaction would accomplish this objective? Assume the counterparties would exchange principal and interest payments with no rate adjustments. What savings are realized by Dell and Virgin? Suppose, in fact, that Dell can borrow dollars at 7 percent and pounds at 9 percent, whereas Virgin can borrow dollars at 8. 75 percent and pounds at 9. 5 percent. What range of interest rates would make this swap attractive to both parties? Based on the scenario in part (c), suppose Dell borrows dollars at 7 percent and Virgin borrows pounds at 9. 5 percent. If the parties swap their current proceeds, with Dell paying 8. 75 percent to Virgin for pounds and Virgin paying 7. 75 percent to Dell for dollars, what are the cost savings to each party? Michael Dimond School of Business Administration

Fixed for Fixed Answer • • A) Virgin would borrow £ 10 million for Fixed for Fixed Answer • • A) Virgin would borrow £ 10 million for two years and Dell would borrow $16 million for two years. The two companies would then swap their proceeds and payment streams. B) Assuming no interest rate adjustments, Dell would pay 8. 5% on the £ 10 million and Virgin would pay 7% on its $16 million. Given that its alternative was to borrow pounds at 9%, Dell would save 0. 5% on its borrowings, or an annual savings of £ 50, 000. Similarly, Virgin winds up paying an interest rate of 7% instead of 8% on its dollar borrowings, saving it 1% or $160, 000 annually. C) Ignoring credit risk differences, Virgin would have to provide Dell with a pound rate of less than 9%. Given that Virgin has to borrow the pounds at 9. 5%, it would have to save at least 0. 5% on its dollar borrowing from Dell to make the swap worthwhile. If Dell borrows pounds from Virgin at 9% - x. then Virgin would have to borrow dollars from Dell at 8. 75% - (0. 5% + x) to cover the 0. 5% + x difference between the interest rate at which it was borrowing pounds and the interest rate at which it was lending those pounds to Dell. D) Under this scenario, Dell saves 0. 25% on its pound borrowings and earns 0. 75% on the dollars it swaps with Virgin, for a total benefit of 1% annually. Virgin loses 0. 75% on the pounds it swaps with Dell and saves 1% on the dollars it receives from Dell, for a net savings of 0. 25% annually. Michael Dimond School of Business Administration

Fixed for Floating Currency Swap Michael Dimond School of Business Administration Fixed for Floating Currency Swap Michael Dimond School of Business Administration

Fixed for Floating Example • Suppose that IBM would like to borrow fixed-rate yen, Fixed for Floating Example • Suppose that IBM would like to borrow fixed-rate yen, whereas Korea Development Bank (KDB) would like to borrow floating-rate dollars. IBM can borrow fixed-rate yen at 4. 5 percent or floating-rate dollars at LIBOR + 0. 25 percent. KDB can borrow fixed-rate yen at 4. 9 percent or floating-rate dollars at LIBOR + 0. 8 percent. a) b) c) What is the range of possible cost savings that IBM can realize through an interest rate/currency swap with KDB? Assuming a notional principal equivalent to $125 million, and a current exchange rate of ¥ 105/$, what do these possible cost savings translate into in yen terms? Redo Parts a and b assuming that the parties use Bank of America, which charges a fee of 8 basis points to arrange the swap. Michael Dimond School of Business Administration

Fixed for Floating Answer • A) The cost to each party of accessing either Fixed for Floating Answer • A) The cost to each party of accessing either the fixed-rate yen or the floating‑rate dollar market for a new debt issue is as follows: • Given the differences in rates between the two markets, the two parties can achieve a combined 15 basis point savings through IBM borrowing floating-rate dollars at LIBOR + 0. 25% and KDB borrowing fixed-rate yen at 4. 9% and then swapping the proceeds. IBM would be able to borrow fixed-rate yen at 4. 35% if all these savings were passed along to it in the swap. This could be accomplished by IBM providing KDB with floating-rate dollars at LIBOR + 0. 25%, saving KDB 0. 55%, which then passed these savings along to IBM by swapping the fixed-rate yen at 4. 9% - 0. 55% = 4. 35%. Thus, the potential savings to IBM range from 0 to 0. 15%. B) At a current exchange rate of ¥ 105/$, IBM's borrowing would equal ¥ 13, 125, 000 (125, 000*105). A 0. 15% savings on that amount would translate into ¥ 19, 687, 500 per annum (¥ 13, 125, 000*0. 0015). C) In this case, the potential savings from a swap net out to 7 basis points. If IBM realizes all these savings, its borrowing cost would be lowered to 4. 43% (4. 5% - 0. 07%). The 7 basis point saving would translate into an annual saving of ¥ 9, 187, 500 (¥ 13, 125, 000*0. 0007). • • Michael Dimond School of Business Administration

Structured Notes • Interest-bearing securities with interest payments determined by a formula set in Structured Notes • Interest-bearing securities with interest payments determined by a formula set in advance and adjusted on specified reset dates. • Formula can be tied to various factors, such as LIBOR, exchange rates, or commodity prices. • Formula may include multiple factors, such as the difference between three-month dollar LIBOR and three-month Swiss franc LIBOR. • Structured notes commonly include one or more embedded derivative elements, such as swaps, forwards, or options. • They have sometimes been used in imprudent ways, such as Inverse Floaters used by Orange County, CA. Michael Dimond School of Business Administration

Forward & Futures Contracts • Forward and futures contracts can be used to manage Forward & Futures Contracts • Forward and futures contracts can be used to manage interest rate risk and debt service costs by locking in interest rates on future loans and deposits. • Examples include forwards, forward rate agreements (FRAs), and Eurodollar futures. Michael Dimond School of Business Administration

Forwards & FRAs • Forward: a contract which fixes an interest rate today on Forwards & FRAs • Forward: a contract which fixes an interest rate today on a future loan or deposit. • The contract specifies the interest rate, the principal amount of the future deposit or loan, and the start and ending dates of the future interest rate period. • Forward forwards have been largely displaced by the forward Rate Agreement (FRA). • Forward Rate Agreement (FRA): a cash-settled, over-thecounter forward contract which fixes an interest rate to be applied to a specified future interest period on a notional principal amount. • Analogous to a forward foreign currency contract but instead of exchanging currencies, the parties to an FRA agree to exchange interest payments. Michael Dimond School of Business Administration

FRA Example • Ford has a $20 million Eurodollar deposit maturing in two months FRA Example • Ford has a $20 million Eurodollar deposit maturing in two months that it plans to roll over for a further six months. The company's treasurer feels that interest rates will be lower in two months time when rolling over the deposit. Suppose the current LIBOR 6 is 7. 875%. How can Ford use an FRA at 7. 65% from Banque Paribas to lock in a guaranteed six-month deposit rate when it rolls over its deposit in two months? • • If after two months, LIBOR 6 has fallen to 7. 5%. How much will Ford receive/pay on its FRA? What will be Ford's hedged deposit rate for the next six-month period? • • Ford today can enter into the FRA and guarantee itself a six-month deposit rate in two months time of 7. 65%. Specifically, Ford will sell a "2 x 6" FRA on LIBOR at 7. 65% to Banque Paribas for a notional principal of $20 million. This means that Banque Paribas Trust has entered into a two-month forward contract on six-month LIBOR. Two months from now, if LIBOR 6 is less than 7. 65%, Banque Paribas will pay Ford the difference in interest expense. If LIBOR 6 exceeds 7. 65%, Ford will pay Banque Paribas the difference. In this case, Ford will receive from Banque Paribas $20, 000 x (0. 0765 - 0. 075)/2 = $15, 000, giving it an annualized hedged deposit rate of 7. 65% for the next six months. If in two months, LIBOR 6 has risen to 8%. How much will Ford receive/pay on its FRA? What will be Ford's hedged deposit rate for the next six months? • Ford will pay Banque Paribas $20, 000 x (0. 08 - 0. 0765)/2 = $35, 000, giving it–as before– an annualized hedged deposit rate of 7. 65% for the next six months. Michael Dimond School of Business Administration

Eurodollar Futures • Eurodollar Future: a cash-settled futures contract on a three month, $1, Eurodollar Futures • Eurodollar Future: a cash-settled futures contract on a three month, $1, 000 Eurodollar deposit that pays LIBOR. • Eurodollar futures contracts are traded on various organized exchanges for March, June, September, and December delivery. • Contracts are traded out to three years, with a high degree of liquidity out to two years. • Eurodollar futures act like FRAs in that they help lock in a future interest rate and are settled in cash. • Unlike FRAs, they are marked to market daily (as in currency futures, this means that gains and losses are settled in cash each day). Michael Dimond School of Business Administration

International Leasing • Cross-border or international leasing can be used to both defer and International Leasing • Cross-border or international leasing can be used to both defer and avoid tax. • It can also be used to safeguard the assets of a multinational firm's foreign affiliates and avoid currency controls. Michael Dimond School of Business Administration

LDC debt-equity swap • LDC = Less Developed Countries • Typically have little industry LDC debt-equity swap • LDC = Less Developed Countries • Typically have little industry and sometimes a high dependence on foreign aid • Under a debt‑equity program, a firm buys a country's dollar debt on the secondary loan market at a discount and swaps it into local equity. • Such swaps create the possibility of cheap financing for expanding plant and retiring local debt in hard‑pressed LDCs. Michael Dimond School of Business Administration