Long-Term FinancingLong-Term Financing

2222 Lecture Lecture

18 - 2

Reducing Exchange Rate Risk

Offsetting cash inflows¤ Foreign currency receipts can help offset

bond payments in the same currency.¤ In particular, an MNC can aggregate its cash

inflows from all euro-zone countries to cover the payments for its euro-denominated bonds.

The exchange rate risk from financing with bonds in foreign currencies can be reduced in various ways.

18 - 3

Reducing Exchange Rate Risk

Forward contracts¤ A firm may hedge its exchange rate risk

through the forward market.¤ However, the firm may not be able to save

costs due to interest rate parity.

Currency swaps¤ A currency swap enables firms to exchange

currencies at periodic intervals.¤ It can be a useful alternative to forward or

futures contracts.

18 - 4

Reducing Exchange Rate Risk

Parallel loans¤ In a parallel (or back-to-back) loan, two

parties simultaneously provide loans to each other (or to a subsidiary of the other party) with an agreement to repay at a specified point in the future.

18 - 5

Subsidiary ofU.K.- based MNC

that is locatedin the U.S.

Provisionof loans

Subsidiary ofU.S.- based MNC

that is locatedin the U.K.

British ParentU.S. Parent

Repaymentof loans in

the currencythat wasborrowed

Illustration of A Parallel Loan

18 - 6

Reducing Exchange Rate Risk

Diversifying among currencies¤ A firm may issue bonds in several foreign

currencies for diversity.¤ To avoid the higher transaction costs

associated with multiple bond issues, the firm may develop a currency cocktail bond.

¤ One popular currency cocktail is the Special Drawing Right (SDR).

18 - 7

Interest Rate Risk from Debt Financing

• An MNC must also decide on the maturity that it should use for its debt.

• If the bond term is too short, the MNC may have to refinance at a higher interest rate.

• However, if the bond term matches the expected business life, the MNC is obligated to continue paying interest at the same rate even when market interest rates fall.

18 - 8

The Debt Maturity Decision

• Before making the debt maturity decision, MNCs may want to assess the yield curves of the countries in which they need funds.

• A yield curve is shaped by the demand for and supply of funds at various maturity levels in a country’s debt market.

• An upward-sloping yield curve means that the annualized yields are lower for short-term debt than for long-term debt.

18 - 9

Yield Curvesas of February 8, 2004

18 - 10

• Some MNCs use a country’s yield curve to compare the annualized rates for different debt maturities.

• Other MNCs use the yield curve as an indicator for future interest rate movements.

• Then MNCs can decide whether to lock in a long-term rate or borrow for a short-term period and refinance in the near future.

The Debt Maturity Decision

18 - 11

The Fixed versus Floating Rate Decision

• MNCs that wish to issue a long-term bond but want to avoid the prevailing fixed rate may consider floating rate bonds.

• For example, the coupon rate is frequently tied to the London Interbank Offer Rate (LIBOR).

• If the coupon rate is floating, forecasts are required for both exchange rates and interest rates.

18 - 12

Hedging with Interest Rate Swaps

• When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk.

• Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa.

• Bond issuers use swaps to reconfigure their future cash flows in a way that offsets their payments to bondholders.

18 - 13

Hedging with Interest Rate Swaps

• Financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee.

• In a plain vanilla swap, the floating rate payer is typically highly sensitive to interest rate changes and seeks to reduce interest rate risk.

18 - 14

Hedging with Interest Rate Swaps

Continuing financial innovation has resulted in a number of variations:¤ Accretion swap – increasing notional value¤ Amortizing swap – decreasing notional value¤ Basis (floating-for-floating) swap¤ Callable swap¤ Forward swap – swap begins at a future date¤ Putable swap¤ Zero-coupon swap¤ Swaption – swap option

18 - 15

• The International Swaps and Derivatives Association (ISDA) is frequently credited with the swap market’s standardization.

• The ISDA is a global trade association representing leading participants in the privately negotiated derivatives industry.

• It developed the Master Agreement and pioneered efforts to identify and reduce risk sources in the derivatives and risk management business.

Hedging with Interest Rate Swaps

18 - 16

• Source: Adopted from South-Western/Thomson Learning © 2006