Bling-Bling Corporation

• Must use IRR function, cannot use ex-post Uncovered Interest Parity, since loan not pure discount arrangement

• Complication: issue costs

• Issue cost % applies to the gross financing

• Gross-up the net financing

Bling-Bling Corporation

• Yen cash flows must be forward hedged

• FX loan: sell loan proceeds at Bid, buy debt service at Ask

• Criterion: Minimize cost of financing in the reference currency (U$)

• Technique: determine vector of U$ cash flows, then apply IRR function

Hedging FX financing cash flows

• Canuck Avions case: one swap.• Bling-Bling case: five forward contracts• Bling-Bling must buy JY288,659,794

forward for years 1, 2, 3, 4, 5 and JY7,216,494,880 for year 5.

• Valid comparison of reference currency vs. FX financing requires that the latter be fully hedged

Principal Repayment Arrangements

• 1. Bond-type: pay only interest; at maturity repay entire principal.

• 2. Mortgage-type: fully amortized with equal annual debt service (blend of interest and principal repayment).

• 3. Type-3: Principal repaid in equal annual installments; debt service declines during loan life.

• Ranked from fastest to slowest pace of principal repayment: 3, 2, 1, 0.

Equal annual repayment of principal (type 3 loan)

• Borrow $1 at 10% over two years.

• Principal repayment = 0.5 per year.

• Interest payments: year1 = $1 x 10% = .1; year2 = $.5 x 10% = .05

• Debt service: year1 = .5 + .1 = .6; year2 = .5 + .05 = .55

• Cash flows: 1; -.6; -.55. IRR = 10%

Tabular format for type 3 loan

Year Principal@Start

Principal Repay.

Interest Payment

Debt Service

1 1 .5 .1 = 1(10%)

.6

2 .5 .5 .05 = .5(10%

)

.55

Effect of up-front fee on pace of principal repayment to minimize all-in cost

• Borrow $1 over 2 years: 10% interest rate, 5% up-front fee

• Grossed-up principal = 1.05263 = 1/(1-.05)

• Mortgage-type loan: 1; -0.6065; -0.6065 implies cost = 13.9%

• Pure-discount bond: 1; 0 ; -1.27368 implies cost = 12.86%

• Choose slow pace of principal repayment to amortize up-front loan processing fee over longer effective time horizon

Effects of loan processing fee (F) and FX-denomination

Situation Pace of Principal Repayment to Reduce Financing Cost

Incur F; no FX Slow

No F; appreciating FX Fast

No F; depreciating FX Slow

Financing in FX

• If FX is projected to depreciate or exhibits a forward discount, repay principal sloooowly (bond-type is best), other things equal.

• If FX is projected to appreciate or exhibits a forward premium, perhaps repay principal ASAP (type-3 is perhaps best), other things equal.

• Why perhaps? In presence of loan processing fees, it is better to postpone principal repayment.

Covered/Uncovered Interest Parity: Implications

• High interest rate currency trades at a forward discount and will depreciate.

• Low interest rate currency trades at a forward premium and will appreciate.

• The two effects work at cross purposes: one raises, the other lowers the cost of financing in the reference currency.

• Implication: Apply Excel’s IRR function!

Dubious Rules of Thumb

• Definitions: soft currency, likely to depreciate; hard currency, likely to appreciate.

• Always finance in a soft currency. Problem: such a currency exhibits high interest rate.

• Always finance in a low interest currency. Problem: such a currency will likely appreciate. Low interest currencies are hard.