210 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
Two remarks are in order. First, the above statement ignores credit risks, as
we have shown: while no value is gained/lost when adding a swap, valueisgained
when an unnecessarily high risk spread is replaced by a better one. We also should
look at various fees and transaction costs, and possible non-neutralities in the tax
law. All this issues make theCFO’s life far more interesting than it would have been
in a perfect world. Second, when stressing theceqproperty, we also assume that
the market knows what it is doing. SomeCFOs may disagree, or at least disagree
some of the time, and turn to speculation. Others may agree that the market rates
are fair but can still have a preference for afcloan, for instance because it hedges
otherfcincome. So even if in terms of market values nothing would be gained or
lost there can still be a preference for a particular currency.
But when swaps are possible, the ultimate currency of borrowing can be separated
from the currency in which the original bank loan is taken up. Thus, we first choose
on the basis of costs. Then we ask the question whether the currency of the cheapest
loan is also the currency we desire to borrow in. If so, then we’re happy already. If
not, then (i) a cheaphcloan can be swapped intofcif desired—e.g. to hedge other
income or to speculate; or (ii) a cheapfcloan can be hedged, if desired. Thus, in
the presence of swap and forward markets it is always useful to split the discussion
of, say, what currency to borrow from what bank, into two parts: (i) what are the
various transaction costs, risk spreads, and tax effects?; and (ii) do we want to
change the currency of lowest-cost solution by adding a swap or a forward?
How would we sum up costs and spreads and so on? Here’s an example. In
the calculations we calculate all costs inpvterms, using the risk-free rate of the
appropriate currency.^19
Example 5.34
Suppose you have three offers for a loan, one year. You needeur1m or, atSt=
1.333,usd1.333m if you borrowusd. Below, I list the asked interest rate, stated as
swap plus spread, and the upfront fee on the loan—a fixed amount and a percentage
cost. How would you chose?
- Bank A:eurat 3% (libor) + 1.0%; upfronteur1000+0.50%
- Bank B:eurat 3% (libor) + 0.5%; upfronteur2000+0.75%
- Bank C:usdat 4% (libor) + 0.9%; upfrontusd1000+0.50%
The computations are straightforward:(^19) Discounting at the risk-free rate is not 100% correct: when we want to find thepv, to the
borrower or lender, of a series of payments we should take a rate that includes default risk. (The
procedure with discounting at the risk-free rate, above, was derived to find equivalent payment
streams from the swap dealer’s point of view, who has a much safer position than the lender.) But
in the presence of upfront fees it is no longer very obvious what the rate on the loan is, and the
error from using the swap rate instead is small. A more in-depth discussion follows in Chapter 16.