8/7/2010

1

Long Term & Short Term Financing Decisionsg

Dr HK pradhan

Objectives

• Cost considerations for long‐term & short termfinancing in foreign currencies

• how to assess the feasibility of long‐term & short term financing in foreign currencies

• how the assessment of long‐term & short term financing in foreign currencies hedged for interest rate and currency risk

Risk from Debt Financing

The Debt Maturity Decision

The Fixed versus Floating Rate Decisions

Currency choice in foreign borrowings

Hedging with Interest Rate & currency Swaps

Loan flexibility structure (currency, interest rate, ….

Cost of Debt Financing

Comparison of fully hedged JPY Vs INR Cost ComparisonNeed

Working Capital Finance to fund imports worth USD 20 Million equivalent

Traditional Solution

INR Working Capital Demand Loan @ 10% p.a. to meet import requirement

Alternative

Foreign Currency Financing thru Buyer’s Credit scheme of RBI I.e. loan from an offshore branch of Citibank N.A

6 month JPY LIBOR 0.66%

Spread over LIBOR 3 00%

All in cost Comparison As on 17th Jul, 09

Spread over LIBOR 3.00%Total Interest Rate before withholding tax (A) 3.66%

10% withholding tax of gross interest (B) 0.407%

6 Month JPY – INR forward premia (C) 2.78%

Fully Hedged 6 month JPY funding cost (including withholding tax) (A + B + C)

6.85%

Total annual cost savings for the client based on USD 20 Million facility for import financing is USD 630,000 or approx Rs 3 crores (USD – INR @ Rs 48) (Translates to a 3 % saving on the borrowing amount)

Key Issues in Measuring Cost of Debt Financing

Decisions based on

1.)  amount of funds needed

2.)forecast of periodic  exchange rate

3.) forecast interest rate

4.) credit spread

5.) hedging costs

6.) compare with domestic financing costs

Concept of All‐In‐Costs

Base rate: Cost of raising funds (say, LIBOR)Spread Over the Base Rate (to cover credit risk)Fees & Commissions

The All‐in‐Costs include three main elements:

Base rate + 

Spread over the Base Rate+  

Fees

8/7/2010

2

All‐in‐Cost of a Syndicated FX Loan• Base Rate 5%     per annum

+• Spread  1.50% per annum

+• Commitment Fee (undrawn) 0.40% per annum• Management Fee (upfront)  0.50% one time• Agency Fee (upfront) US$500 per annumAgency Fee (upfront) US$500 per annum• ‘out‐of‐pocket’ expenses 0.25% one time

– (including VAT)+

• Withholding Taxes 0.75% per annum• Insurance fee Paid  0.50 % One time

• +• Currency Depreciation 2.5 % per annum• Cost of Hedging x%  per annum

IRR‐valuation with sensitivity• Set the net dollar proceeds from the loan• Set the expected LIBOR from the term structure• Annualize all other fees and spread• Set the expected depreciation of the home currency vis‐à‐vis FC• Use forward rates, if available, to compute home currency cash

flows• Calculate the IRR of the cash flows under each LIBOR‐FC

Scenario• Determine the most appropriate LIBOR‐FC rate over the time

horizon• Select the loan if the resultant IRR meets the financing criteria• Compare with home currency loan rate for the period

Chase Syndicated Commercial Loan Proposal(Projected LIBOR and Exchange Rate)

Facility Amount 100,000,000$ LIBOR 7 % Arr. Fees 100 bpsMargin 1 % Rate of dep 5 %

LIBOR Interest CF ($) Rs/$ Rs.0 -99,000,000 32 -3,168,000,000 -3,168,000,0001 7 4,000,000 4,000,000 33 131,200,000 131,200,0002 7.5 4,250,000 4,250,000 34 142,885,000 131,024,5073 8 4,500,000 4,500,000 34 155,072,250 130,396,4834 8.5 4,750,000 4,750,000 35 167,779,559 129,370,940, , , , , , , ,5 9 5,000,000 5,000,000 36 181,025,314 127,997,9136 9.5 5,250,000 5,250,000 37 194,828,494 126,322,8607 10 5,500,000 5,500,000 38 209,208,693 124,387,0298 10.5 5,750,000 5,750,000 39 224,186,133 122,227,8049 11 6,000,000 6,000,000 40 239,781,690 119,879,018

10 11.5 6,250,000 6,250,000 41 256,016,909 117,371,24311 12 6,500,000 6,500,000 42 272,914,025 114,732,06312 12.5 6,750,000 6,750,000 43 290,495,986 111,986,32213 13 7,000,000 7,000,000 44 308,786,474 109,156,35114 13.5 7,250,000 107,250,000 45 4,849,326,154 1,571,947,467

0IRR% 18.10 0 =SUM(I10:I24)

Assessing the Exchange Rate Risk of Debt Financing

Use of Exchange Rate & interest RATE ProbabilitiesOne approach to using point estimates of future exchange rates is to develop a probability distribution for an exchange rate for each period in which payments will  be made to bondholders.

The expected value of the exchange  rate can be computed for each period by multiplying each possible exchange rate by its associated probability and totaling the products.

The exchange rate’s expected value can be used to forecast the cash outflows necessary to pay bondholders over each period.

Choose the IRR that meets your financing criteria 

Simulated IRR (%)

Options Expected Rs Dep 3 4 5 6 7 Actual

Syndicated Loan 15.75 16.93 18.10 19.28 20.46 14.36Eurobond (7 years) 13.64 14.80 15.97 17.13 18.30 16.66Eurobond (10 years) 13.29 14.43 15.57 16.71 17.84 15.97Floating Rate Loan 12.49 13.64 14.79 15.95 17.10 15.46ECA- USA Floating 15.37 16.54 17.72 18.89 20.06 13.93ECA- Japan 15.37 16.54 17.71 18.89 20.06 16.24ECA- Germany 15.37 16.54 17.71 18.89 21.24 9.45

8/7/2010

3

Hedging Issues

• Short term hedging – (forwards, futures)

• Long term hedging ( )– (swaps)

Interest Rate Risk Management  using FRAs

• Suppose you will need a 1‐year loan in  1‐year from now

• How one can fix the rate of such a loan today?

• Forward rates as quoted by banks can be used to fix these future interest rates

• Interest rate forward rates are implied future rates, which are derived from the zero coupon yields

FRAs Fixing Future Borrowing Rate

Using 1 & 2 Yrs spot rate, you lock in your borrowing rate for both periods 1 and 2.

Clearly all of the cash flows and risks will be the same. Thus r0,1 and r0,2 must have an equivalence with f1,2.

Using 2Yr forward contracts (f1,2), you  lock in your borrowing rates at time 0 for the periods between 1 and 2.

0 1                   2                        

No Arbitrage FRAs

s1= 3.567%s2=3.896%

f12 = 4.226%

222x2

204226.1

203567.1

203896.01 ⎟

⎠

⎞⎜⎝

⎛ +⎟⎠

⎞⎜⎝

⎛ +=⎟⎠

⎞⎜⎝

⎛ +

Interest Rate Swap Structure

Determining Swap Payments

• Plain Vanilla Swap

• Other Types of Interest Rate Swaps

• Standardization of the Swap Market

8/7/2010

4

Interest Rate Swaps

• An agreement between two parties in which each party makes a series of LIBOR interest payments and receives fixed interest rate (say, b d th US t i ld) t th thbased on a the US treasury yield) to the other counterparty at predetermined dates.– An agreement to exchange interest payments– fixed for floating– at predetermined  dates– based on notional principal– denominated in the same currency 

Interest Rate Swap

• An agreement  to receive 6‐month LIBOR & pay a fixed rate of 5.00% pa every 6 months for 3 years on a notional principal of USD100 million

• The above swap can be expressed as:

Original Loan Servicing

IBRD Borrower 

5.00%

LIBOR

LIBOR+ 0.5

Borrower’s Cash Flows Under a Swap

LIBOR Floating Fixed NetDate Rate Cash Flow Cash Flow Cash Flow

03/01/04 4 2%03/01/04 4.2%09/01/04 4.8% +2.10 –2.50 –0.40

03/01/05 5.3% +2.40 –2.50 –0.10

09/01/05 5.5% +2.65 –2.50 +0.1503/01/06 5.6% +2.75 –2.50 +0.25

09/01/06 5.9% +2.80 –2.50 +0.3003/01/07 6.4% +2.95 –2.50 +0.45

Interest Rate Cap

• A cap fixes the maximum interest rate payable, at the same time allowing the borrower to take advantage of the lower rates

time

cap

Interest Rate Floor

• A Floor fixes the minimum interest rate payable, on a floating rate instrument

time

floor

Interest Rate Collar

• Combination of a cap and a floor• Floating rate borrower buying the collar (a) Purchases the cap option to 

limit the maximum interest rate he will pay (b), and at the same time  sells the floor option to obtain a premium to pay for the cap

time

floor

cap

8/7/2010

5

Currency Swap

• An exchange of one currency against another– An exchange of principal at the outset and a re‐exchange at maturitymaturity

– Current spot rate is normally used in both exchanges

– On‐going interest payments are made based on spot

– Can be applied to new or existing exposure

– Original liability remains intact

Bank Bank

$ principal £ equivalent

Currency SwapIn a currency swap agreement, principal repayments and interest payments denominated in US $ is exchanged against £, for a specified future period  at the current (agreed) exchange rate

Borrower Borrower

Investor Investor

$ interest

£ payment$ payment

$ principal

Currency Swap: ExamplePRESENT  POSITION

Outstanding  debt : £ 100 million

Interest :  7%

Maturity :  5 years

Current Exchange Rate : $2.00/£

OBJECTIVE :   Swap to $ liability, as the dollar is expected depreciate.

Swap Terms : Principal : $200 MILLIONInterest :  5% p.a.

Maturity :  5 years

$10 M $10 M $10 M $10 M $10 M

$200 M

• Swap terms • £ 100 million @ 7%  vs $200 million @ 5% p.a.• Exchange rate $2.00/£

Currency Swap: Example

£7 M

£100 M

£7 M £7 M £7 M £7 M

Year 1       Year 2       Year 3         Year 4  Year 5     Year 5

MIFOR SWAPMumbai Interbank Forward Offer Rate ‐MIFOR 

• MIFOR was a mix of the London Interbank Offer Rate (LIBOR) and a forward premium derived from Indian forex markets 

• Intention of MIFOR was for hedging purposes• Intention of MIFOR was for hedging purposes. However, many corporate entities used MIFOR for currency speculation 

• RBI since allowed for MIFOR to be only used in interbank related transactions  

MIFOR Swap: An ExampleAn agreement to receive 6‐month MIFOR & pay a fixed rate of 6.5.00% pa every 6 months for 3 years on a notional principal of Rs 100 million

B k C

6.5%

Bank Company

MIFORMIFOR+ 1.00

The formula for Mifor computation is as follows:Mifor = {[1 + Libor * No of Days / 365] * [1+USD/INR Forward Premia(%) *

No of Days / 365] - 1} * (365/Total No of Days)

8/7/2010

6

Nov 05(Reuters) ‐ The FIMMDA‐REUTERS‐MIOCS (Mumbai Interbankoffered Currency Swaps) for three years was 4.58 

percent onWednesday

• TENOR            BID/OFFER   • 2 YEARS          3.94/4.24   • 3 YEARS          4.30/4.58  • 5 YEARS 5 75/6 04• 5 YEARS          5.75/6.04   • 7 YEARS          6.40/6.80  • 10 YEARS        7.49/7.88• The above dollar rupee swap rates are a simple average of the bid and offer 

rates quoted by 11 market participants. The floating benchmark used here is the six month USD libor. 

• FIMMDA is the Fixed Income Money Market and Derivatives Association of 

India.

• Key issue is to forecast exchange rates, interest rates

• Choice of currency is also an important variablevariable

• Hedging ahead of changes in exchange rates and interest rates

Thank YouThank You