16.1. “EURO” DEPOSITS AND LOANS 611
cycles, with spreads widening when something bad happens, then competition
gradually narrowing the spread until a new bad event happens and so on.^9
In principle, the fees are compensation for the services of the intermediaries,
while the spread is a compensation for default risk. However, one can trade a higher
up-front fee for a lower spread, and vice versa. For instance, borrowers often accept
a high up-front fee in return for a lower spread because the spread is sometimes seen
as a quality rating. One corollary of the trading of up-front fees for risk spreads is
that the spread that country X pays may be a poor indicator of the creditworthiness
of country X: an ostensibly reassuring spread may have been bought off by a large
upfront fee. Another corollary is that reliable comparisons between offers from
competing banks can be made only if there is a single, overall measure of cost. Thus,
when comparing offers from competing syndicates, one should convert the up-front
fees into equivalent spreads, or the spreads and paying-agent fees into equivalent
up-front costs.
Example 16.4
Suppose that an up-front fee ofusd 425,000 is asked on a five-year loan ofusd
10,000,000 with an annual interest payment of 5 percent (including spreads) and
one single amortization at the loan’s maturity date. The effective proceeds of the
loan are, therefore,usd10,000,000 – 425,000 =usd9,575,000. The effective interest
rate can be estimated by computing the internal rate of return or yield, denoted by
y, on the transaction:
findy: 9, 575 ,000 =500 , 000
1 +y+
500 , 000
(1 +y)^2+...+
10 , 500 , 000
(1 +y)^5. (16.2)
This equation can be solved on a spreadsheet or on a calculator. The solution is,
approximately,y= 6.0092 percent, which is about 1 percent above the stated rate.
Conversely, the up-front fee is equivalent to adding 1 percentp.a. to the stated
rate.
In the above example, the future payments are known because the loan had a
fixed interest rate. If the loan has a floating rate, one can no longer compute the
yield because the future cash flows are unknown. However, the up-front fee can
still be translated into an equivalent annual payment or equivalent annuity, using
the interest rate on a fixed-rate loan with the same life and the same default risk.
(To get the required number, simply ask a quote for a fixed-for-floating swap). The
equivalent annuity can then be converted into an equivalent percentage spread by
dividing the annuity by the loan’s nominal value.
Example 16.5
We use the same data as in the previous example except that the loan has a floating
(^9) The famous hedge fund Long-Term Capital Management (LTCM) was betting on a shrinking
spread when, instead, a very bad thing happened, Russia’s default. Betting again on a falling
spread, LTCM was again wrong-footed, notably by the Asian crises. That was the beginning of the
end for LTCM.