International Finance Chapter 18 Addendum: Financing and Investing Short Term

International Finance

• Chapter 18

• Addendum: Financing and Investing Short Term

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.

• When obligations associated with current (and due) liabilities exceeds cash and marketable securities, the firm will consider borrowing short term.

• 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

• When borrowing in international money markets, the firm must consider two issues:

• 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.

Impact of Exposure on Borrowing Cost

• 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.