Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise.
Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in each of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to take over the franchise.
Today’s spot exchange rate between the Euro and Wirtonia $ is €0·1430 = $1. The predicted inflation rates are as follows:
Buryecs Co’s finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for the initial fee paid for the franchise, with a swap of principal immediately and in three years’ time, both these swaps being at today’s spot rate. Buryecs Co’s bank would charge an annual fee of 0·5% in € for arranging the swap. Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% of the bank fees.
Relevant borrowing rates are:
In order to provide Buryecs Co’s board with an alternative hedging method to consider, the FD has obtained the following information about over-the-counter options in Wirtonia $ from the company’s bank.
The exercise price quotation is in Wirtonia $ per €1, premium is % of amount hedged, translated at today’s spot rate.
Discuss the advantages and drawbacks of using the currency swap to manage financial risks associated with the franchise in Wirtonia.
The currency swap will involve Buryecs Co taking out a loan in € and making an arrangement with a counterparty in Wirtonia, which takes out a loan in $. Buryecs Co will pay the interest on the counterparty’s loan and vice versa.
Advantages
Payment of interest in $ can be used to match the income Buryecs Co will receive from the rail franchise, reducing foreign exchange risk.
The swap can be used to change Buryecs Co’s debt profile if it is weighted towards fixed-rate debt and its directors want a greater proportion of floating rate debt, to diversify risk and take advantage of probable lower future interest rates.
Drawbacks
The counterparty may default. This would leave Buryecs Co liable to pay interest on the loan in its currency. The risk of default can be reduced by obtaining a bank guarantee for the counterparty.
The swap may not be a worthwhile means of hedging currency risk if the exchange rate is unpredictable. If it is assumed that exchange rates are largely determined by inflation rates, the predicted inflation rate in Wirtonia is not stable, making it more difficult to predict future exchange rates confidently. If the movement in the exchange rate is not as expected, it may turn out to have been better for Buryecs Co not to have hedged.
Buryecs Co is swapping a fixed rate commitment in the Eurozone for a floating rate in Wirtonia. Inflation is increasing in Wirtonia and there is a risk that interest rates will increase as a result, increasing Buryecs Co’s finance costs.
The swap does not hedge the whole amount of the receipt in Year 3. Another method will have to be used to hedge the additional receipt from the government in Year 3 and the receipts in the intervening years.
If the government decides to impose exchange controls in Wirtonia, Buryecs Co may not be able to realise the receipt at the end of Year 3, but will still have to fulfil the swap contract.
(i) Calculate the annual percentage interest saving which Buryecs Co could make from using a currency swap, compared with borrowing directly in Wirtonia, demonstrating how the currency swap will work. (4 marks)
(ii) Evaluate, using net present value, the financial acceptability of Buryecs Co operating the rail franchise under the terms suggested by the government of Wirtonia and calculate the gain or loss in € from using the swap arrangement. (8 marks)
(i)
After paying the 30 point basis fee, Buryecs Co will effectively pay interest at the bank rate – 0·3% and benefit by 90 basis points or 0·9%. The counterparty will effectively pay interest at 5·2% and benefit by 60 basis points or 0·6%.
(ii) Using the purchasing power parity formula to calculate exchange rates:
Calculate the results of hedging the receipt of $7,500 million using the currency options and discuss whether currency options would be a better method of hedging this receipt than a currency swap.
Receipt using swap arrangement = €715m + €329m = €1,044m
Receipt if transaction unhedged = $7,500m x 0·1315 = €986m
Predicted exchange rate at year 3 is €0·1315 = $1 or $7·6046 = €1
Options
Buy $ put options as receiving $.
$7·75 exercise price
Do not exercise
Net receipt = €986m – (1·6% x $7,500m x 0·1430) = €969m
$7·25 exercise price
Exercise
Receipt from government = $7,500m/7·25 = €1,034m
Net receipt = €1,034m – (2·7% x $7,500m x 0·1430) = €1,005m
The $7·25 option gives a better result than not hedging, given the current expectations of the exchange rate. However, it gives a worse result than the swap even before the premium is deducted, because of the exchange rate being fixed on the swap back of the original amount paid. These calculations do not take into account possible variability of the finance costs associated with the swap, caused by swapping into floating rate borrowing.