International Finance: Putting Theory Into Practice

198 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT

risk-free rate. Being an avid reader of this textbook, he knows that the difference
between the two riskfree rates reflect the market’s opinion on the two currencies;
no value is created or destroyed, everything else being the same, if one switches
one risk-free loan for another, both at the risk-free rates. But the risk spreads are
different: one can pay too much, here, and Don Diego especially feels that two
percent in a strong currency (nok) is not attractive relative to 2 percent extra on
the Peso.

If, for some exogenous reason, Don Diego prefersnokoverclp, the solution is
to borrowclpand swap intonok:

P. Sercu and R. Uppal The International Finance Workbook page 4. 20

5. 2. Avoiding inconsistent risk spreads with swaps

5. Swapping

• Example: Same (interbank) data, but you borrow at a risk spread of (^) {^22 %% iinn^ DITELM

• The borrower prefers (for some reason) to borrow DEM but thinks the risk spread a bit
  stiff.


• Borrowing ITL and swapping allows the borrower to borrow de facto DEM and still keep
  the lower spread.

110

1

1. 23

1/100

110 , (^000100)
8 , 930. 9 89.^4309

• Synthetic DEM loan with DEMT = 1


• generates DEMt =


• so you borrow at


• Direct DEM loan costs 12 %
  IfFCTis set at 100,000, then a direct loan at 12 percent producesFCt= 100, 000 / 1 .12 =
  89 , 285 .71; but the swapped Peso loan (FCT→HCT→HCt→FCt) yields 100,000
  ×110 / 1.23 /100 = 89,430.90. Stated differently, Don Diego can borrow synthetic
  nok@ (100,000 – 89,430.90)/89,430.90 = 11.81 percent instead of 12 percent.

One message is that, when comparing corporate loans in different currencies,
one should look at risk spreads not total interest rates. Second, when comparing
spreads we should also take into account the strength of the currency. For example,
2 percent in s strong currency is worse than 2 percent in a low one. We show, below,
that the strength of the currency is adequately taken care of by comparing thePVs
of the risk spreads, each computed at the currency’s own risk-free rate: a 2 percent
risk spread in a low-interest-rate currency then has a higherPVthan a 2 percent
spread in a high-rate currency. A related point, relevant for credit managers who
need to translate a risk spread fromhctofc, is that two spreads are equivalent
if theirPVs are identical. Note that these results hold for zero-coupon loans; the
version for bullet loans with annual interest follows in Chapter 7.

Example 5.21

• Don Diego can immediately note that, for theclpalternative, the discounted
  spread is 0.02/1.21 = 1.65289 percent, better then thenokPVof 0.02/1.10 =
  1.81818 percent.


• Don Diego’s banker can compute that, when quoting anokspread that is
  compatible with the 2 percent asked onclploans, he can ask only 1.81 percent:
  0. 02
  
  
  1. 21
  
  
  
  

=

0. 0181

1. 10

= 0. 0165289. (5.9)

This, as we saw before, is exactly the rate that Don Diego got when borrowing

clpand swapping.