5.5. USING FORWARD CONTRACTS (4): MINIMIZING THE IMPACT OF MARKET
IMPERFECTIONS 197
You should have found that if the tax rule also holds for loans, then one would like
to borrow in a weak currency, one that delivers an untaxed capital gain that is paid
for, in risk-adjusted expectations terms, by a huge tax-deductable interest.
Note, finally, that there could be other tax asymmetries—for instance, capital
losses being treated differently from capital gains. In that case the optimal in-
vestment rules are very different. Connoisseurs will see that in that case the tax
asymmetry works like a currency option—a financial instrument whose pay-off de-
pends on the future spot rate in different ways depending on whetherSTis above
or below some critical number. To analyse this we need a different way of thinking
than what we did just now.
DoItYourself problem 5.3
(For this DoItYourself assignment you do need to know the basics of option pricing.)
Suppose there is a tax rule that says that corporations can deduct capital losses on
long-term loans from their taxable income but they need not add capital gains to
taxable income. Explain why this is different from the case above. Then show that,
in this case, there always is an incentive to borrowunhedgedfcregardless of the
interest rates. (Hint: re-express the effect of this tax rule in terms of the pay-off
from an option.) Finally, show that, when choosing among manyfc’s, you would
go for the highest-volatility one, holding constant the interest rates.
5.5.3 Swapping for Information-cost Reasons
Until now we ignored credit risk. In reality evenAAAborrowers pay a credit-risk
spread on top of the risk-free rate. If a firm compareshcandfcborrowing, it is
quite conceivable that the credit-risk spread on thefcloan is incompatible with the
one on thehcalternative. For instance, if both loans are offered by the same bank,
the credit analyst may have been sloppy, or may simply not have read this section
of the textbook on how to translate risk spreads. Or, more seriously, thefcloan
offer may originate from a foreign bank which has little information, knows it has
little information, and therefore asks a stiff spread just in case.^11 The rule then is
that a spot-forward swap allows the company to switch the currency of borrowing
while preserving the nice spread available in another currency.
Example 5.20
Don Diego Cortes can borrowclpfor 4 years at 23 percent effective, 2 percent above
the risk-free rate; and he can borrownokat 12 percent, also 2 percent above the
(^11) Banks hate uncertainty. When they are facing an unfamiliar customer, they particularly fear
adverse selection. That is, if the bank adds too stiff a credit-risk premium the customer will refuse,
leaving the bank no worse off; but if the bank asks too little, the borrower will jump at it, leaving
the bank with a bad deal. In short, unfamiliar customers too often mean bad deals.