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Bling-Bling Corporation

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.

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Bling-Bling Corporation

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  1. 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

  2. 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

  3. 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

  4. 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.

  5. 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%

  6. Tabular format for type 3 loan

  7. 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

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

  9. 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.

  10. 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!

  11. 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.

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