Chapter Twelve

Sovereign Risk
Solutions for End-of-Chapter Questions and Problems: Chapter Twelve
1. What risks are incurred when making loans to borrowers based in foreign countries?
Explain.
When making loans to borrowers in foreign countries, two risks need to be considered. First, the
credit risk of the project needs to be examined to determine the ability of the borrower to repay
the money. his analysis is based strictly on the economic !iability of the project and is similar in
all countries. "econd, unlike domestic loans, creditors are exposed to so!ereign risk. "o!ereign
risk is defined as the uncertainty associated with the likelihood that the host go!ernment may not
make foreign exchange a!ailable to the borrowing firm to fulfil its payment obligations. hus,
e!en though the borrowing firm has the resources to repay, it may not be able to do so because of
actions beyond its control. hus, creditors need to account for so!ereign risk in their decision
process when choosing to in!est abroad.
#. What is the difference between debt rescheduling and debt repudiation?
$oan repudiation refers to a situation of outright default where the borrower refuses to make any
further payments of interest and principal. %n contrast, loan rescheduling refers to temporary
postponement of payments during which time new terms and conditions are agreed upon between
the borrower and lenders. %n most cases, these new terms are structured to make it easier for the
borrower to repay.
&. %dentify and explain at least four reasons why rescheduling debt in the form of loans is easier
than debt in the form of bonds.
he reasons why it is easier to reschedule debt in the form of bank loans than bonds, especially in
the context of post'war lending in international financial markets, include(
a) $oans usually are made by a small group *syndicate) of banks as opposed to bonds that are
held by indi!iduals and institutions that are geographically dispersed. E!en though
bondholders usually appoint trustees to look after their interests, it has pro!en to be much
more difficult to appro!e renegotiation agreements with bondholders in contrast to bank
syndicates.
b) he group of banks that dominate lending in international markets is limited and hence able
to form a cohesi!e group. his enables them to act in a unified manner against potential
defaults by countries.
c) +any international loans, especially those made in the post'war period, contain cross'default
clauses, which make the cost of default !ery expensi!e to borrowers. ,efaulting on a loan
would trigger default clauses on all loans with such clauses, pre!enting borrowers from
selecti!ely defaulting on a few loans.
1
d) %n the case of post'war loans, go!ernments were reluctant to allow banks to fail. his meant
that they would also be acti!ely in!ol!ed in the rescheduling process by either directly
pro!iding subsidies to pre!ent repudiations or pro!iding incenti!es to international agencies
like the %+F and World -ank to pro!ide other forms of grants and aid.
.. What two country risk assessment models are a!ailable to in!estors? /ow is each model
compiled?
he Euromoney %ndex was originally published as the spread of the Euromarket interest rate for a
particular country0s debt o!er $%-12. he index was adjusted for !olume and maturity. he
index recently has been replaced by a large number of subjecti!ely determined economic and
political factors.
he %nstitutional %n!estor %ndex is based on sur!eys of the loan officers of major multinational
banks who subjecti!ely gi!e estimates of the credit 3uality of gi!en countries. he scores range
from 4 for certain default to 144 for no probability of default.
5. What types of !ariables normally are used in a 627 8'score model? ,efine the following
ratios, and explain how each is interpreted in assessing the probability of rescheduling.
he models typically use micro' and macroeconomic !ariables that are considered important in
explaining the probability of a country0s credit rescheduling.
a. ,ebt ser!ice ratio. he debt ser!ice ratio *,"2) di!ides interest plus amorti9ation on
debt by exports. -ecause interest and debt payments normally are paid in hard
currencies generated by exports, a larger ratio is interpreted as a positi!e signal of a
pending debt rescheduling possibility.
b. %mport ratio. he import ratio *%2) di!ides total imports by total foreign exchange
reser!es. 7 growing amount of imports relati!e to F: reser!es indicates a greater
probability of credit restructuring. his ratio is positi!ely related to debt rescheduling.
c. %n!estment ratio. he in!estment ratio *%;<2) measures the in!estment in real or
producti!e assets relati!e to gross national producti!e. 7 larger in!estment ratio is
considered a signal that the country will be less likely to re3uire rescheduling in the
future because of increased producti!ity= thus the relationship is negati!e. /owe!er,
because the bargaining position of the country will be enhanced, some obser!ers feel that
the relationship is positi!e. hat is, a stronger ratio gi!es the country more power to
re3uest, e!en demand, rescheduling to achie!e e!en better terms on its debt.
d. <ariance of export re!enue. Export re!enues are subject to both 3uantity and price risk
due to demand and supply factors in the international markets. %ncreased !ariance is
interpreted as a positi!e signal that rescheduling will occur because of the decreased
certainty that debt payments will be made on schedule.
e. ,omestic money supply growth. 2apid domestic money supply growth indicates an
increase in inflationary pressures which typically means a decrease in the !alue of the
currency in international markets. hus, real output often is negati!ely impacted, and
#
the probability of rescheduling increases.
>. What are the shortcomings introduced by using traditional 627 models and techni3ues?
/ow does each of the problems impact the estimation techni3ues? %n each case, what
adjustments are made in the estimation techni3ues to compensate for the problems?
he following six items often are listed as problems in using these statistical models. First,
measuring the !ariables accurately and in a timely manner often is difficult because of data
accessibility. "econd, the choice of rescheduling or not rescheduling often is not a dichotomous
situation. %n effect, many other payment alternati!es may be a!ailable through negotiation. hird,
political risk factors are extremely difficult to 3uantify. Fourth, the portfolio affects of lending to
more than one country are not considered. hus the true amount of systematic risk added to the
portfolio may be less than estimated by e!aluating the rescheduling probability of countries
independently. Fifth, statistical models are ill'prepared or designed to e!aluate the incenti!es of
both the borrowers and the lenders to negotiate a rescheduling of the debt. -orrowers benefit by
lowering the present !alue of future payments at the expense of reducing the openness of the
market to future borrowing as well as withstanding potentially ad!erse effects on trade. $enders
benefit by a!oiding a possible default, collecting additional fees, and perhaps reali9ing tax benefits.
$enders, howe!er, may also be subject to greater scrutiny by regulatory authorities and may ha!e
permanent changes in the maturity structure of their asset portfolios. Finally, many of the key
!ariables suffer from the problem of stability. hat is, predicti!e performance in the past may not
be good indicators of predicti!e performance in the future.
?. 7n F% manager has calculated the following !alues and weights to assess the credit risk and
likelihood of ha!ing to reschedule the loan. From the 8'score calculated from these weights
and !alues, is the manager likely to appro!e the loan? <alidation tests of the 8'score model
indicated scores below 4.544 likely to be nonreschedulers, while scores abo!e 4.?44
indicated a likelihood of rescheduling. "cores between 4.544 and 4.?44 do not predict well.
Country
ariable alue !eight
,"2 1.#5 4.45
%2 1.>4 4.14
%;<2 4.>4 4.&5
<72E: 4.15 4.&5
+@ 4.4# 4.15
8 A 4.45,"2 B 4.15%2 B 4.&4%;<2 B 4.&5<72E: B 4.15+@
A 4.45*1.#5) B 4.15*1.>4) B 4.&4*4.>4) B 4.&5*4.15) B 4.15*4.4#)
A 4..CC
his score classifies the borrower as a probable nonrescheduler.
C. 6ountries 7 and - ha!e exports of D# and D> billion, respecti!ely. he total interest and
amorti9ation on foreign loans for both countries are D1 and D# billion, respecti!ely.
a. What is the debt ser!ice ratio *,"2) for each country?
&
,"2 A
Exports Total
on Amortizati Plus Interest
,"27 A D1ED# A 4.54 ,"2- A D#ED> A 4.&&
b. -ased only on this ratio, to which country should lenders charge a higher risk premium?
-ased on the abo!e information, lenders should charge a higher risk premium on loans to
6ountry 7 because it has more interest and amorti9ation payments due as a percentage of
total exports.
c. What are the shortcomings of using only these ratios to determine your answer in *b)?
his is a !ery static model and such a preliminary conclusion could be misleading. %t is also
necessary to consider other factors which may be more fa!orable for 6ountry 7. $ooking
forward, it is also possible that 6ountry 7 may be at its de!eloping stage where imports and
loans are needed to increase future exports. /istorically, most of the industriali9ed countries
were net importers of capital during their de!eloping stages. Without a comprehensi!e
analysis of the fundamentals, it is not possible to judge the 3uality of the borrower.
F. Explain the following relation(
p A f *IR, INVR)
B, B or '
p A Grobability of rescheduling
%2 A otal imports E otal foreign exchange reser!es
%;<2 A 2eal in!estmentE@;G
his relation states that the probability of a country=s rescheduling of its foreign debt is a
positi!e function of %2 but it may be positi!ely or negati!ely related to INVR(
IR A otal importsEotal F: reser!es. %f imports as a percentage of F: reser!es increase,
it lea!es less foreign exchange for payments of debt. 7s a result, there is a higher
likelihood that the country may ha!e to reschedule its debt.
INVR A 2eal in!estmentE@;G. %f a country has higher sa!ings and higher in!estments, it
should lead to higher growth, reducing the likelihood of rescheduling. his supports the
negati!e sign of the relationship. 1n the other hand, it is possible that the higher growth
puts the country in a stronger bargaining position with its lenders and, conse3uently, it
may be less intimidated by the threat of default. his may make the likelihood of
rescheduling higher, suggesting a positi!e relationship between p and INVR.
14. What is systematic risk in terms of so!ereign risk? Which of the !ariables often used in
statistical models tend to ha!e high systematic risk? Which !ariables tend to ha!e low
systematic risk?
"ystematic risk refers to the risk effects that cannot be di!ersified away by lending to more than
one country. %n effect, some international economic situations will affect the economies of less
de!eloped countries in a similar manner. Economic research indicates that the ,"2 and the
.
<72E: both ha!e high systematic risk elements. +oney supply growth and the import ratio
seem to ha!e low systematic risk elements.
11. What are the benefits and costs of rescheduling to the following?
a. 7 borrower?
-enefits and costs to the borrower( *a) %t could reduce its immediate payments and increase
imports for the present. %t could also reduce the o!erall payments, depending on the
rescheduling agreements. *b) %t could result in either no loans being appro!ed in the future
or the imposition of more stringent re3uirements. %t could also result in higher premiums on
other trade instruments, such as letters of credit.
b. 7 lender?
-enefits and costs to the lenders( *a) %t impro!es the likelihood that the lender will recei!e
full payment of its interest and principal as opposed to an outright default. *b) he
restructured loan, on a present !alue basis, may be higher then the existing present !alue of
the loan. *c) here may be tax ad!antages to writing off some portions of the loan, so the
present !alue of the complete package may be higher than the current present !alue of the
loan. *d) -anks may be stuck holding loans that are of longer maturity with higher risk.
e) 2escheduled loans may be a burden on the lender=s remaining assets, and markets may
penali9e the lender for holding on to loans that are hard to dispose of.
1#. /ow do price and 3uantity risks affect the !ariability of a country0s export re!enue?
Huantity risk refers to the !ariability in the amount of a commodity produced. his is most likely
to be found in agricultural products subject to fa!orable and unfa!orable weather conditions.
Grice risk refers to the !ariability in the commodity price due to changes in market conditions,
e.g., competitors0 supply changes or consumer demand changes.
1&. he a!erage
#
E2 *or <72E: A !ariance of export re!enue) of a group of countries has
been estimated at #4 percent. he indi!idual <72E: of two countries in the group,
/olland and "ingapore, has been estimated at 15 percent and #C percent, respecti!ely. he
regression of indi!idual country <72E: on the a!erage <72E: pro!ides the following
beta *coefficient) estimates(
/ A -eta of /olland A 4.C4= " A -eta of "ingapore A 4.#4.
a. -ased only on the <72E: estimates, which country should be charged a higher risk
premium? Explain.
-ased on the <72E: measure alone, risk premiums should be lower for loans made to the
;etherlands because its <72E: is lower than "ingapore=s. <72E: measures the !olatility
of the export re!enues and is one measure of the ability of countries to repay foreign debt.
b. %f F%s include systematic risk in their estimation of risk premiums, how would your
conclusions to part *a) be affected? Explain.
5
"ince the systematic beta of "ingapore is lower than that of the ;etherlands, it will reduce
the o!erall systematic risk of an F%=s portfolio of foreign loans. %n this case, it benefits the
F% to add "ingapore to its list of countries because its unsystematic risk can be di!ersified
away. hus, if the industriali9ed countries, including the ;etherlands, are experiencing a
recession and a decline in export re!enues, "ingapore=s exports are likely to be unaffected
as e!idenced by the low beta. his implies that the debt repayments between these two
countries are not highly correlated, helping to reduce the bank=s total risk.
1.. Who are the primary sellers of $,6? Who are the buyers? Why are F%s often both sellers
and buyers of $,6 debt in the secondary markets?
he primary sellers of $,6 debt include large F%s who are willing to accept write'downs of loans
and small F%s who no longer wish to be in!ol!ed with the $,6 market. -uyers tend to be
wealthy in!estors, hedge funds, F%s, and corporations who wish to use debt'e3uity swaps to
further in!estment goals. F%s that are both buyers and sellers often do so to readjust their balance
sheets to meet corporate goals.
15. %dentify and describe the four market segments of the secondary market for $,6 debt.
-rady bonds are recollaterali9ed loans that ha!e lower coupon interest rates and longer maturities
than the original loans. he principal usually is collaterali9ed with the purchase of I.". treasury
bonds by the issuing country. 7lthough yields are lower, the -rady bonds ha!e more acceptability
in the secondary markets than the original loans.
"o!ereign bonds constitute the second largest segment of the $,6 debt market. hese bonds are
issued to repay -rady bonds, and thus they ha!e higher credit risk premiums because they no
longer ha!e the cost of the I.". treasury collateral.
Gerforming loans are the original or restructured so!ereign loans on which the originating country
continues to remain current in the payment of interest and principal.
;onperforming loans are traded in the secondary markets at deep discounts because of
nonpayment situations.
he following 3uestions and problems are based on material presented in 7ppendix 1>'7.
1>. What are the risks to an in!esting company participating in a debt'e3uity swap?
,ebt'e3uity swap in!estors often face long periods before they can repatriate di!idends, often
ha!e large withholding tax restrictions, ha!e the long'term problem of potential expropriation or
nationali9ation of assets, and face significant foreign exchange currency risk.
1?. 6hase -ank holds a D#44 million loan to 7rgentina. he loans are being traded at bid'offer
prices of F1'F& per 144 in the $ondon secondary market.
>
a. %f 6hase has an opportunity to sell this loan to an in!estment bank at a ? percent
discount, what are the sa!ings after taxes compared to selling the loan in the secondary
market? 7ssume the tax rate is .4 percent.
he price that 6hase could obtain from the in!estment bank is D#44*1 J 4.4?) A D1C>m.
he tax loss benefit is D1.m x 4..4 A D5.>m, for a net price of D1C>m B D5.> A D1F1.>4.
%n the secondary market, it would ha!e had to sell the loans at F1cents on the dollar or D1C#
million. he tax loss benefit is D1Cm x 4..4 A D?.#m for a net price of D1CF.#4. herefore,
the sa!ings from selling the loans to the in!estment bank as opposed to the secondary
market is D1F1.>4 ' D1CF.#4 A D#.. million.
b. he in!estment bank in turn sells the debt at a > percent discount to a real estate
company planning to build apartment complexes in 7rgentina. What is the profit after
taxes to the in!estment bank?
he in!estment bank purchased the loan for D1C> million, and it sells the loan for D1CC
million *D#44m*1 J 4.4>) A D1CCm). hus profit before taxes is D1CC ' D1C> A D# million,
and profit after taxes is D#*1 ' 4..4) A D1.#4 million.
c. he real estate company con!erts this loan into pesos under a debt'e3uity swap
organi9ed by the 7rgentinean go!ernment. he official rate for dollar to peso con!ersion
is G1.45ED. he free market rate is G1.14ED. /ow much did the real estate company
sa!e by in!esting in 7rgentina through the debt'e3uity swap program as opposed to
directly in!esting D#44 million using the free market rates?
%f the real estate company had in!ested directly, it would ha!e recei!ed D#44 x 1.14 A ##4
million pesos. -y purchasing through the debt'e3uity swap, the company pays D1CC million
and recei!es D#44 x 1.45 A #14 million pesos, for an e3ui!alent rate of #14E1CC A G1.11?ED.
hus, it still sa!es by purchasing through the debt'for'e3uity swap *G1.11?ED K G1.14ED).
d. /ow much would 6hase benefit from doing a local currency debt'e3uity swap itself?
Why doesn0t the bank do this swap?
7ssuming the bank could con!ert the loan at D1CC million in to pesos at G1.45ED, the after
tax effect would be D1CCm plus the tax loss benefit A D1CCm B D1#*4..4) A D1F#.C million.
he actual benefit was D1F1.> million. hus the bank would gain D1.# million.
6hase is not allowed to participate in real e3uity purchases in other countries by Federal
2eser!e 2egulation L, nor is it allowed to engage in commerce in other countries. Further,
a long'term pesos'denominated position on the balance sheet may create more credit,
li3uidity, and foreign exchange risk than the benefits are worth.
1C. 8lick 6ompany plans to in!est D#4 million in 6hile to expand its subsidiary0s manufacturing
output. 8lick has two options. %t can con!ert the D#4 million at the current exchange rate of
.14 pesos to a dollar, *i.e., G.14ED), or it can engage in a debt'e3uity swap with its bank
6ity -ank by purchasing 6hilean debt and then swapping that debt into 6hilean e3uity
in!estments.
?
a. %f 6ity -ank 3uotes bid'offer prices of F.'F> for 6hilean loans, what is the bank
expecting to recei!e from 8lick 6orporation *ignore taxes)? Why would 6ity -ank
want to dispose off this loan?
6ity -ank expects to recei!e F> cents to the dollar since it is selling this loan, i.e. 4.F> x
#4m A D1F.#4 million. %t may wish to sell this loan to reduce its portfolio of troubled or bad
3uality assets. 7s I.". banks experienced problems with se!eral of their foreign loans, their
choices were limited to either writing off the loans or disposing of them. he de!elopment
of an acti!e secondary market has made it easier for F%s to sell them at a discount and
rearrange their composition of loans.
b. %f 8lick decides to purchase the debt from 6ity -ank and con!ert it to e3uity, it will ha!e
to exchange it at the official rate of G.44ED. %s this option better than in!esting directly in
6hile at the free market rate of G.14ED?
%f exchanged at market rates( D#4m x G.14 A GC,#44 million, for an effecti!e rate of G.14ED.
%f exchanged through a debt'for'e3uity swap( D#4m x G.44 A GC,444 million, for an
effecti!e price of C,444E1F.#4 A G.1>.>?ED. herefore, 8lick should choose the debt'for'
e3uity swap option.
c. What official exchange rate will cause 8lick to be indifferent between the two options?
For the options to be e3ual, the effecti!e price must be(
*#4 M x)E1F.#4 A .14 AK x A *.14 x 1F.#4)E#4 A G&F&.>4ED
he 6hilean go!ernment could reduce the official rate to as low as G&F&.>4ED and the two
options will still be e3ual. his is because the discount obtained from the secondary market
is substantial.
1F. What is "on"essionality in the process of rescheduling a loan?
6oncessionality refers to the net cost to the F% in restructuring a loan. he amount of
concessionality is determined by subtracting the present !alue of the restructured loan from the
present !alue of the original loan.
#4. Which !ariables typically are negotiation points in an $,6 multiyear restructuring
agreement *+N27)? /ow do changes in these !ariables pro!ide benefits to the borrower
and to the lender?
he fi!e common elements typically found in the +N27 negotiation include(
*a) 7 fee charged by the bank to co!er the cost of the restructuring.
*b) he interest rate on the loan is usually lowered to allow easier repayment of the loan by the
borrowing country.
*c) 7 grace period may be created to allow the country to build a reser!e of hard currency from
which it can repay the loan.
C
*d) he maturity of the loan normally is lengthened. his process reduces the periodic payment
stream for the borrower country.
*e) <arious option and guarantee features may allow the lender to choose the currency for
repayment, andEor to pro!ide protection in the case of default.
#1. /ow would the restructuring, such as rescheduling, of so!ereign bonds affect the interest
rate risk of the bonds? %s it possible that such restructuring would cause the bank0s cost of
capital not to change? Explain.
o the extent that the bonds ha!e increased maturity and lower interest rates, the duration of these
bonds will ha!e increased. hus the interest rate risk will ha!e increased. While it is possible that
the bank0s cost of capital will not change, a bank with a significant portion of its assets in $,6
debt that has been restructured will likely find an ad!erse adjustment in its cost of capital.
##. 7 bank is in the process of renegotiating a loan. he principal outstanding is D54 million and
is to be paid back in two installments of D#5 million each, plus interest of C percent. he
new terms will stretch the loan out to 5 years with no principal payments except for interest
payments of > percent for the first three years. he principal will be paid in the last two
years in payments of D#5 million along with the interest. he cost of funds for the bank is >
percent for both the old loan and the renegotiated loan. 7n up'front fee of 1 percent is to be
included for the renegotiated loan.
a. What is the present !alue of the existing loan for the bank?
he present !alue of the loan prior to rescheduling is(
Gayment in Near 1( Grincipal B %nterest A D#5m B 4.4C M D54 A D#Fm
Gayment in Near #( Grincipal B %nterest A D#5m B 4.4C M D#5 A D#?m
G< A G<nA1, kA> *D#F) B G<nA#, kA> *D#?) A D51.&CC. million
b. What is the present !alue of the rescheduled loan for the bank?
%nterest payments in years 1, # and &( 4.4> x D54 A D&m
Gayment in Near .( Grincipal B %nterest A D#5m B 4.4> M D54 A D#Cm
Gayment in Near 5( Grincipal B %nterest A D#5m B 4.4> M D#5 A D#>.5m
G< A G<7nA&, kA> *D&) B G<nA., kA> *D#C) B G<nA5, kA> *D#>.5) A D54 million
Ip'front fee A 4.41 x D54 A D4.54 million
G< *total) A D54.54 million
c. %s the concessionality positi!e or negati!e for the bank?
6oncessionality A G<o ' G<R A G< of old loan ' G< of rescheduled loan
A D51.&CC. ' D54.54 A D4.CC. million
#&. 7 bank is in the process of renegotiating a three'year nonamorti9ing loan. he principal
outstanding is D#4 million, and the interest rate is C percent. he new terms will extend the
loan to 14 years at a new interest rate of > percent. he cost of funds for the bank is ?
F
percent for both the old loan and the renegotiated loan. 7n up'front fee of 54 basis points is
to be included for the renegotiated loan.
a. What is the present !alue of the existing loan for the bank?
G< of old loan A G<%F7nA&,kA?O*D1.>m) B G<%FnA&,kA?O*D#4m) A D#4.5#.F million
b. What is the present !alue of the rescheduled loan for the bank?
G< of new loan A G<%F7nA14,kA?O*D1.#m) B G<%FnA14,kA?O*D#4m) B up'front fee of D4.14m
A D1C.5F5& million B D4.14 million A D1C.>F5& million
c. What is the concessionality for the bank?
6oncessionality A D#4.5#.Fm ' D1C.>F5&m A D1.C#F> million
d. What should be the up'front fee to make the concessionality 9ero?
6oncessionality A D#4.5#.Fm ' D1C.5F5&m ' x A 4 x A D1.F#F> million or F.>5 percent.
#.. 7 D#4 million loan outstanding to the ;igerian go!ernment is currently in arrears with 6ity
-ank. 7fter extensi!e negotiations, 6ity -ank agrees to reduce the interest rates from 14
percent to > percent and to lengthen the maturity of the loan to 14 years from the present 5
years remaining to maturity. he principal of the loan is to be paid at maturity. here will no
grace period and the first interest payment is expected at the end of the year.
a. %f the cost of funds is 5 percent for the bank, what is the present !alue of the loan prior
to the rescheduling?
%nterest payments in years 1 ' 5( 4.14 x D#4 A D#m
G< A G<7nA5,kA5*D#) B G<nA5,kA5*D#4) A D#..&#F5 million
b. What is the present !alue of the rescheduled loan to the bank?
%nterest payments in years 1 ' 14( 4.4> x D#4 A D1.#m
G< A G<7nA14,kA5*D1.#) B G<nA14,kA5*D#4) A D#1.5..& million
c. What is the concessionality of the rescheduled loan if the cost of funds remain at 5
percent and an up'front fee of 5 percent is charged?
Ip'front fee A 4.45 x D#4m A D1 million
G< *total) A D#1.5..& million B D1 million A D##.5..& million
6oncessionality A G<o ' G<R A G< of old loan ' G< of rescheduled loan
A D#..&#5F ' D##.5..& A D1.?C5# million
d. What up'front fee should the bank charge to make the concessionality e3ual 9ero?
he bank has to increase its up'front fees by D1.?C5# for a total of D#.?C5#, or 1&.F&O.
14
#5. 7 bank was expecting to recei!e D144,444 from its customer based in @ermany. "ince the
customer has problems repaying the loan immediately, the bank extends the loan for another
year at the same interest rate of 14 percent. /owe!er, in the rescheduling agreement, the
bank reser!es the right to exercise an option of recei!ing the payment in deutsche marks,
,+1C1,544, con!erted at the current exchange rate of ,+1.>5ED.
a. %f the cost of funds to the bank is also assumed to be 14 percent, what is the !alue of this
option built into the agreement if only two possible rates are expected at the end of the
year, ,+1.?5ED or ,+1.55ED, with e3ual probability?
Without the option, the amount expected at the end of the year A D114,444. %f the mark
depreciates to ,+1.?5ED, the amount recei!ed by the bank is the maximum of D114,444, or
1C1,544E1.?5 A D14&,?1..#F. %f the mark appreciates to ,+1.55ED, the amount recei!ed by
the bank is the maximum of D114,444, or 1C1,544E1.55 A D11?,4F>.??. With the option, the
expected amount recei!ed is 4.54*D114,444) B 4.54*D11?,4F>.??) A D11&,5.C.&F. he
present !alue of the option is D11&,5.C.&F ' D114,444 A D&,5.C.&FE1.1 A D&,##5.C1
b. /ow would your answer differ, if the probability of the ,+ being ,+1.?5ED is ?4O and
,+1.55ED is &4O?
With the option, the expected amount recei!ed is 4.?4*D114,444) B 4.&4*D11?,4F>.??) A
D11#,1#F.4&. he present !alue of the option A D11#,1#F.4& ' D114,444 A D#,1#F.4&E1.1 A
D1,F&5..C.
c. ,oes the currency option ha!e more or less !alue as the !olatility of the exchange rate
increases?
he option will ha!e more !alue as the !olatility of the exchange rate increases.
#>. What are the major benefits and costs of loan sales to an F%?
he benefits of loan sales to an F%(
*a) hey remo!e bad loans from the balance sheet, freeing resources for other in!estments as
well as impro!ing the F%=s portfolio composition.
*b) hey may signal to market in!estors that the bank is in a position to bear losses. his
hypothesis has been confirmed by empirical studies showing stock prices reacting fa!orably
to news of banks adding additional reser!es to co!er loan reser!es.
*c) $osses can be deducted, pro!iding write'offs for the bank.
he costs of loan sales to an F%(
*a) here is an actual loss e3ual to the face !alue less the market !alue.
*b) "econdary loan prices are !ery !olatile and can fluctuate dramatically, making the planning
of the optimal time to sell'off difficult.
11
#?. What are the major costs and benefits of con!erting debt to -rady bonds for an F%?
he ad!antage of con!erting debt to a -rady bond for an F% is its increased li3uidity, which makes
it an attracti!e instrument to hold. -rady bonds are also cleared through two major clearing
houses, Euroclear and 6edel, resulting in lower transaction costs and lower bid'ask prices. 7
disad!antage is that -rady bonds ha!e much longer maturities and there is usually a loss entailed
because the restructured !alue of the bond is usually lower than the present !alue of the loan.
1#