196 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
Table 5.2:HCand swappedFCinvestments if only interest is taxedInvestclp 100 Investnok1 and hedge
initial investment 100.00 1 ×100 = 100.00
final value 100 ×1.21 = 121.00 [1×1.10]×110 = 121.00
income 21.00 21.00
interest 21.00 [1×0.10]×110 = 11.00
capgain 0 110 – 100 = 10.00
Neutral taxes, 33.33%
taxable 21.00 21.00
tax (33.33 %) 7.00 7.00
after-tax income 14.00 14.00
Only interest is taxed, 33.33%
taxable 21.00 11.00
tax (33.33 %) 7.00 3.67
after-tax income 14.00 17.33transaction cost, if there is another advantage: fiscal, legal, or in terms of credit-
risk spreads. We start with the tax issue.
5.5.2 Swapping for Tax Reasons
In the previous chapter we saw that swappedfcdeposits and loans should yield
substantially the same rate before tax, and therefore also after tax if the system
is neutral. But in many countries, under personal taxation, capital gains are tax
exempt and capital losses not deductible while interest income is taxed. A swapped
fcdeposit in a strong currency then offers an extra tax advantage: part of the
income is paid out as a capital gain and is, therefore, not taxed. In Table 5.2, we
go back to an example from the previous chapter and add the computations for the
case where capital gains/losses are not part of taxable income. The swappednok
deposit now offers aclp3.33 extra because of the tax saved on theclp10 capital
gain.
If this is the tax rule, the implications for a deposit are as follows:- If thefcrisk-free rate is above the domestic rate, thehcdeposit does best;
- When there are many candidate foreign currencies: the lower thefcinterest
rate, the higher the forward premium, so the bigger the capital gain and
therefore the larger the tax advantage.
DoItYourself problem 5.2
What are the rules for a loan instead of a deposit?