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International Finance. Chapter 18 Addendum: Financing and Investing Short Term. BORROWING AND INVESTING IN INTERNATIONAL MONEY MARKETS.
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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.
