8/7/2010

Objectives
• Cost considerations for long‐term & short term
financing in foreign currencies
Long Term & Short Term  • how to assess the feasibility of long‐term & short 
Financing Decisions
g term financing in foreign currencies
• how the assessment of long‐term & short term 
Dr HK pradhan financing in foreign currencies hedged for interest 
rate and currency risk

Comparison of fully hedged JPY Vs INR Cost Comparison
Risk from Debt Financing Need
Working Capital Finance to fund imports worth USD 20 Million equivalent
Traditional Solution
INR Working Capital Demand Loan @ 10% p.a. to meet import requirement
The Debt Maturity Decision Alternative
Foreign Currency Financing thru Buyer’s Credit scheme of RBI I.e. loan from an offshore branch of Citibank N.A

The Fixed versus Floating Rate Decisions All in cost Comparison As on 17th Jul, 09

Currency choice in foreign borrowings 6 month JPY LIBOR 0.66%

Spread over LIBOR 3 00%

3.00%
Hedging with Interest Rate & currency Swaps Total Interest Rate before withholding tax (A) 3.66%

10% withholding tax of gross interest (B) 0.407%

Loan flexibility structure (currency, interest rate,  6 Month JPY – INR forward premia (C) 2.78%

…. Fully Hedged 6 month JPY funding cost (including

withholding tax) (A + B + C)
6.85%

Cost of Debt Financing Total annual cost savings for the client based on USD 20 Million facility for import
financing is USD 630,000 or approx Rs 3 crores (USD – INR @ Rs 48) (Translates to a 3
% saving on the borrowing amount)

Key Issues in Measuring Cost of 
Concept of All‐In‐Costs
Debt Financing
Base rate: Cost of raising funds (say, LIBOR)
Decisions based on
Spread Over the Base Rate (to cover credit risk)
1.)  amount of funds needed Fees & Commissions
2.)forecast of periodic  exchange rate The All‐in‐Costs include three main elements:
3.) forecast interest rate
Base rate 
4.) credit spread + 
Spread over the Base Rate
5.) hedging costs
+  
6.) compare with domestic financing costs Fees

1
 8/7/2010

All‐in‐Cost of a Syndicated FX Loan
• Base Rate 5%     per annum
+
• Spread  1.50% per annum
+
• Commitment Fee (undrawn) 0.40% per annum
• Management Fee (upfront)  0.50% one time
• Agency Fee (upfront)
Agency Fee (upfront) US$500 per annum
US$500 per annum
• ‘out‐of‐pocket’ expenses 0.25% one time
– (including VAT)
+
• Withholding Taxes 0.75% per annum
• Insurance fee Paid  0.50 % One time
• +
• Currency Depreciation 2.5 % per annum
• Cost of Hedging x%  per annum

Chase Syndicated Commercial Loan Proposal

IRR‐valuation with sensitivity (Projected LIBOR and Exchange Rate)

• Set the net dollar proceeds from the loan Facility Amount $ 100,000,000
LIBOR 7% Arr. Fees 100 bps
• Set the expected LIBOR from the term structure Margin 1% Rate of dep 5%

• Annualize all other fees and spread LIBOR Interest CF ($) Rs/$ Rs.
0 -99,000,000 32 -3,168,000,000 -3,168,000,000
• Set the expected depreciation of the home currency vis‐à‐vis FC 1 7 4,000,000 4,000,000 33 131,200,000 131,200,000
• Use forward rates, if available, to compute home currency cash 2
3
7.5
8
4,250,000
4,500,000
4,250,000
4,500,000
34
34
142,885,000
155,072,250
131,024,507
130,396,483
flows 4 8.5 , ,
4,750,000 4,750,000
, , 35 167,779,559
, , 129,370,940
, ,
5 9 5,000,000 5,000,000 36 181,025,314 127,997,913
• Calculate the IRR of the cash flows under each LIBOR‐FC 6 9.5 5,250,000 5,250,000 37 194,828,494 126,322,860
Scenario 7 10 5,500,000 5,500,000 38 209,208,693 124,387,029
8 10.5 5,750,000 5,750,000 39 224,186,133 122,227,804
• Determine the most appropriate LIBOR‐FC rate over the time 9 11 6,000,000 6,000,000 40 239,781,690 119,879,018
10 11.5 6,250,000 6,250,000 41 256,016,909 117,371,243
horizon 11 12 6,500,000 6,500,000 42 272,914,025 114,732,063
• Select the loan if the resultant IRR meets the financing criteria 12
13
12.5
13
6,750,000
7,000,000
6,750,000
7,000,000
43
44
290,495,986
308,786,474
111,986,322
109,156,351
• Compare with home currency loan rate for the period 14 13.5 7,250,000 107,250,000 45 4,849,326,154 1,571,947,467
0
IRR% 18.10 0 =SUM(I10:I24)

Assessing the Exchange Rate Risk of  Choose the IRR that meets your 
Debt Financing financing criteria 
Use of Exchange Rate & interest RATE 
Probabilities Simulated IRR (%)

One approach to using point estimates of future exchange  Options
rates is to develop a probability distribution for an exchange  Expected Rs Dep 3 4 5 6 7 Actual
rate for each period in which payments will  be made to  Syndicated Loan 15.75 16.93 18.10 19.28 20.46 14.36
Eurobond (7 years) 13.64 14.80 15.97 17.13 18.30 16.66
bondholders.
Eurobond (10 years) 13.29 14.43 15.57 16.71 17.84 15.97
The expected value of the exchange  rate can be computed  Floating Rate Loan 12.49 13.64 14.79 15.95 17.10 15.46
for each period  by multiplying each possible exchange  ECA- USA Floating 15.37 16.54 17.72 18.89 20.06 13.93
rate by its associated probability and totaling the products. ECA- Japan 15.37 16.54 17.71 18.89 20.06 16.24
ECA- Germany 15.37 16.54 17.71 18.89 21.24 9.45
The exchange rate’s expected value can be used to forecast 
the cash outflows necessary to pay bondholders over 
each period.

2
 8/7/2010

Hedging Issues Interest Rate Risk Management  using FRAs
• Short term hedging 
• Suppose you will need a 1‐year loan in  1‐year from 
– (forwards, futures)
now
• Long term hedging  • How one can fix the rate of such a loan today?
– (swaps)
( ) • Forward rates as quoted by banks can be used to fix 
these future interest rates
• Interest rate forward rates are implied future rates, 
which are derived from the zero coupon yields

FRAs Fixing Future Borrowing Rate

Using 1 & 2 Yrs spot rate, you lock in your borrowing rate for both periods 1 and 2.

0 1                   2                        

Clearly all of the cash flows and risks will be the same. Thus r0,1 and r0,2 must have 
an equivalence with f1,2.

Using 2Yr forward contracts (f1,2), you  lock in your borrowing rates at time 0 for the 
periods between 1 and 2.

Interest Rate Swap Structure
No Arbitrage FRAs
Determining Swap Payments
s1= 3.567% • Plain Vanilla Swap
s2=3.896%
• Other Types of Interest Rate Swaps
• Standardization of the Swap Market
f12 = 4.226%

2x 2 2 2
⎛ 0.03896 ⎞ ⎛ .03567 ⎞ ⎛ .04226 ⎞
⎜1 + ⎟ = ⎜1 + ⎟ ⎜1 + ⎟
⎝ 2 ⎠ ⎝ 2 ⎠ ⎝ 2 ⎠

3
 8/7/2010

Interest Rate Swap
Interest Rate Swaps
• An agreement  to receive 6‐month LIBOR & pay a fixed rate of 5.00% pa 
every 6 months for 3 years on a notional principal of USD100 million
• An agreement between two parties in which  • The above swap can be expressed as:
each party makes a series of LIBOR interest 
payments and receives fixed interest rate (say, 
b d
based on a the US treasury yield) to the other 
th US t i ld) t th th 5.00%
counterparty at predetermined dates. IBRD Borrower 
– An agreement to exchange interest payments
LIBOR
– fixed for floating
– at predetermined  dates
LIBOR+ 0.5
– based on notional principal
Original Loan Servicing
– denominated in the same currency 

Borrower’s Cash Flows Under a Swap Interest Rate Cap

LIBOR Floating Fixed Net • A cap fixes the maximum interest rate 

Date Rate Cash Flow Cash Flow Cash Flow payable, at the same time allowing the 
03/01/04 4 2%
4.2%
borrower to take advantage of the lower rates
09/01/04 4.8% +2.10 –2.50 –0.40
cap
03/01/05 5.3% +2.40 –2.50 –0.10
09/01/05 5.5% +2.65 –2.50 +0.15
03/01/06 5.6% +2.75 –2.50 +0.25
09/01/06 5.9% +2.80 –2.50 +0.30
03/01/07 6.4% +2.95 –2.50 +0.45 time

Interest Rate Floor Interest Rate Collar

• Combination of a cap and a floor
• Floating rate borrower buying the collar (a) Purchases the cap option to 
• A Floor fixes the minimum interest rate payable,  limit the maximum interest rate he will pay (b), and at the same time  
on a floating rate instrument sells the floor option to obtain a premium to pay for the cap

cap
floor
floor

time
time

4
 8/7/2010

Currency Swap
Currency Swap In a currency swap agreement, principal repayments and interest payments 
denominated in US $ is exchanged against £, for a specified future period  at the 
current (agreed) exchange rate

• An exchange of one currency against another Bank
Bank
– An exchange of principal at the outset and a re‐exchange at  $ principal
maturity £ equivalent
$ payment £ payment
– Current spot rate is normally used in both exchanges
– On‐going interest payments are made based on spot Borrower Borrower
– Can be applied to new or existing exposure
– Original liability remains intact $ interest $ principal

Investor Investor

Currency Swap: Example
• Swap terms 
Currency Swap: Example • £ 100 million @ 7%  vs $200 million @ 5% p.a.
PRESENT  POSITION • Exchange rate $2.00/£ $200 M
Outstanding  debt : £ 100 million
$10 M $10 M $10 M $10 M $10 M
Interest :  7%
Maturity :  5 years
Current Exchange Rate : $2.00/£
OBJECTIVE :   Swap to $ liability, as the dollar is 
expected depreciate.
Swap Terms : Principal : $200 MILLION £7 M £7 M £7 M £7 M £7 M
Interest :  5% p.a.
Maturity :  5 years £100 M
Year 1       Year 2       Year 3         Year 4  Year 5     Year 5

MIFOR SWAP
Mumbai Interbank Forward Offer Rate ‐ MIFOR  MIFOR Swap: An Example
An agreement to receive 6‐month MIFOR & pay a fixed rate of 6.5.00% pa 
• MIFOR was a mix of the London Interbank  every 6 months for 3 years on a notional principal of Rs 100 million
Offer Rate (LIBOR) and a forward premium 
derived from Indian forex markets  6.5%

• Intention of MIFOR was for hedging purposes. 
Intention of MIFOR was for hedging purposes B k
Bank C
Company

However, many corporate entities used MIFOR  MIFOR
MIFOR+ 1.00
for currency speculation 
The formula for Mifor computation is as follows:
• RBI since allowed for MIFOR to be only used in  Mifor = {[1 + Libor * No of Days / 365] * [1+USD/INR Forward Premia(%) *
interbank related transactions   No of Days / 365] - 1} * (365/Total No of Days)

5
 8/7/2010

Nov 05(Reuters) ‐ The FIMMDA‐REUTERS‐MIOCS (Mumbai 
Interbankoffered Currency Swaps) for three years was 4.58 
percent onWednesday
• TENOR            BID/OFFER    • Key issue is to forecast exchange rates, 
• 2 YEARS          3.94/4.24    interest rates
• 3 YEARS          4.30/4.58   • Choice of currency is also an important 
• 5 YEARS
5 YEARS          5.75/6.04   
5 75/6 04 variable
• 7 YEARS          6.40/6.80   • Hedging ahead of changes in exchange rates 
• 10 YEARS        7.49/7.88 and interest rates
• The above dollar rupee swap rates are a simple average of the bid and offer 
rates quoted by 11 market participants. The floating benchmark used here is 
the six month USD libor. 
• FIMMDA is the Fixed Income Money Market and Derivatives Association of 
India.

Thank You
Thank You