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.