International finance concepts and applications

International Finance

In order to determine which currency is the cheapest to borrow in, the effective financing rate for each must be calculated. For the Australian dollar, the effective financing rate is 8%, which is the one-year interest rate. For the other currencies, the effective financing rate will need to be calculated.

$500 AUD in JPY will be JPY 44,642 this year. The interest rate is 4%, so the repayment will be JPY 46,428. The expected spot rate is one year for AUD/JPY is .015, so in one year JPY 46,428 will be worth AUD 696.43. This is an effective interest rate of 39.29%. This calculation can be repeated for the other currencies as well:

Foreign

Effective

AUD Amount

Rate

in foreign

interest

S1 foreign

S1 rate

S1 AUD

Rate

Yen

0.0112

44642.86

46428.57

0.015

USD

0.9162

0.045

€

1.3594

AUD

It is recommended that the company borrow in U.S. dollars. The table above shows the effective rate for borrowing in each currency. The effective rate reflects the cost of money for the firm if we were to borrow in a foreign currency, then repay in that currency. The cost of U.S. dollars is the lowest, followed by the cost of Australian dollars. The other currencies have a higher cost of borrowing. It should be remembered that the cost of borrowing is dependent on the future cost of the currency exchange. This cost is estimated based on the current expected cost of that currency in one year's time. While this could change, the change is not expected to be so significant as to overcome the disparity in the effective rates of these different currencies. Thus, the U.S. dollar option is recommended.

Task 2. It has been accepted that the debt will be financed in U.S. dollars. In one year's time, the debt may need to be refinanced. A forward rate agreement can be used to help hedge against rates being higher at that time. It is expected that the rates are going to be 150 basis points higher in one year. A forward rate agreement would lock in the cost of debt in one year.

In order to execute this hedge, the company would purchase a two-year forward rate today. This would effectively lock in today's expected two-year forward rate. So for example, today the rates are expected to be 150 basis points higher, which means that the USD rate is going to be 6% for the second year. Because all four currencies are expected to see their interest rates increase by the same amount, the relative cost of the currencies will not change -- the U.S. dollars will still be cheapest. If we sign a forward today we will lock in a rate of 6% if we need to refinance; if we wait that rate could be higher in a year's time. Thus, the forward rate today locks in today's expected rate for that time period.

The forward contract would be for two years, to deliver sufficient USD to pay for the loan in two years' time. The amount would be $604 million USD, given 6% interest in the second year.

Task 3. There are a number of types of bonds that could be issued by Development Unlimited. These include straight fixed debt, zero coupon bonds and floating rate notes. Straight fixed debt is also known as plain vanilla bonds. These come with a fixed rate of interest on the debt. They are typically bearer bonds as well. The company will simply pay a coupon interest rate for the set period and then at the end of the period will repay the principle as well.

The second type is a zero coupon bond. For this type of bond, the return is taken as a discount on the price of the bond. There are no periodic interest payments. The zero coupon bond is riskier for the purchaser because the cash flows are entirely at the end of the period. The advantage of the zero coupon is that it is simple, and can be used for short time frames. The disadvantage of a zero coupon is the greater risk to the buyer over long time frames. The issuer would need to compensate for this.