International Finance
BORROWING AND INVESTING IN INTERNATIONAL MONEY MARKETS As part of their work capital management responsibilities, global firms will need to operate in international money markets. Activities in these markets occurs as follows: 1) Borrowing short-term funds. Firms will enter international money markets to finance cash shortfalls. 2) Investing short-term funds. Firms will enter the international money markets to earn interest on “excess” funds. - When cash held exceeds current (and due) liabilities, the firm will look to place funds in short-term international money market instruments.
THE EFFECTIVE COST OF SHORT TERM BORROWING 1) The market interest rate on borrowed funds and, 2) The (anticipated) change in the exchange rate during the period that the funds will be borrowed. - Prior to paying back the borrowed funds.
- This needs to be considered because the firm has an exposed foreign currency position or the period up to repayment.
If the foreign currency appreciates, the “effective” cost of borrowing increases. Why? - It will take more home currency to pay off the debt. Thus,
- Effective borrowing cost = market interest rate + foreign currency appreciation.
Impact of Exposure on Cost of Borrowing If the foreign currency depreciates, the “effective” cost of borrowing decreases. Why? - It will take less home currency to pay off the debt. Thus,
- Effective borrowing cost = market interest rate – foreign currency depreciation.
Calculating Effective Cost of Borrowing Thus, as part of the international money market financing decision, a firm must consider both the market interest rate it will be paying on its debt and the likely exchange rate change during the period that its debt is outstanding, or: Rf = (1 + if)(1 + ef) – 1 - Where:
- Rf = is the effective financing rate.
- if = is the market interest rate.
- ef = is the expected (percentage) change in the foreign currency against the firm’s home currency.
Example Assume a U.S. firm is quoted a borrowing rate in Switzerland of 4% on a one-year loan. The U.S. firm has forecasted a change in the Swiss franc from $.50/SFr on the day the loan is made to $.55/SFr on the day the loan is to be paid back. Use this information to calculate the effective cost of borrowing in Switzerland.
Example Calculate the expected change in the Swiss franc: - Expected change = (forecast - current)/current), or
- ($.55 - .50)/.50 = .05/.50 = .10 (10.0%), then
Using the effective rate formula: - Rf = (1 + if)(1 + ef) - 1
= (1 + .04)(1 + .10) - 1 = (1.04)(1.10) - 1 = 1.144 - 1 = .144 (or 14.4%)
Example Now assume that your forecast for the Swiss franc called for an exchange rate of $.49/Sfr one year from now. Given this assumption and the information above, calculate the effective cost of borrowing Swiss francs.
Example Calculate the expected change in the Swiss franc: - Expected change = (forecast - current)/current), or
- ($.49 - .50)/.50 = -0.1/.50 = -0.2 (-2.0%)
Using the effective rate formula: - Rf = (1 + if)(1 + ef) - 1
= (1 + .04)(1 - 0.02) - 1 = (1.04)(.98) - 1 = 1.0192 – 1 = .0192 (or 1.92%)
THE EFFECTIVE COST OF SHORT TERM BORROWING WITH A FORWARD COVER In the previous two examples, the effective cost of borrowing was calculated on the basis of the firm having an uncovered position in the foreign currency. Question? - What if we elect to cover the exposure associated with the borrowing?
Covering the Exposure The effective rate formula can also be used to incorporate the cost of a forward cover (given that the forward rate will provide us with a “exact” future exchange rate). The formula to determine the effective “covered” cost of short-term borrowing is: Rfc = (1 + if)(1 +/- c) - 1 Where: Rfc = is the effective covered financing rate. if = is the market interest rate. c = is the forward discount or premium for the foreign currency against its spot. Note: If the foreign currency is selling at a discount, you subtract (-c) and if it is selling at a premium, you add (+c).
Example Assume a U.S. firm is quoted a borrowing rate in Switzerland of 4% on a 1-year loan. The U.S. firm has been given a forward 1-year quote of –1% (the franc is selling at a discount of its spot of 1%). Using this information, calculate the effective covered cost of borrowing in Swiss francs. Rfc = (1 + if)(1 +/-c) - 1 = (1 + .04)(1 -.01) - 1 = (1.04)(.99) - 1 = 1.0296 - 1 = .0296 (or 2.96%)
Example Assume that the Swiss franc is quoted at a 2% premium of its spot. The calculated covered cost of borrowing under this assumption is: Rfc = (1 + if)(1 +/-c) - 1 = (1 + .04)(1 +.02) - 1 = (1.04)(1.02) - 1 = 1.0608-1 = .0608 (or 6.08%)
Summary In example 1, the forward discount on the Swiss franc decreased the effective borrowing cost. In example 2, the forward premium on the Swiss franc increased the effective cost. Reason: A discount on the foreign currency means it will take less of your home currency to pay the liability and a premium means it will take more.
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