currency denomination in long-term debt financing and refinancing: a cross- hedging paradigm

Currency Denomination in Long-Term Debt Financing and Refinancing: A Cross- HedgingParadigmAuthor(s): Laurent L. Jacque and Pascal LangSource: The Journal of the Operational Research Society, Vol. 38, No. 2 (Feb., 1987), pp. 173-182Published by: Palgrave Macmillan Journals on behalf of the Operational Research SocietyStable URL: http://www.jstor.org/stable/2582152 .

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J. Opl Res. Soc. Vol. 38, No. 2, pp. 173-182, 1987 0160-5682/87 $3.00 + 0.00 Printed in Great Britain. All rights reserved Copyright (C 1987 Operational Research Society Ltd

Currency Denomination in Long-term Debt Financing and Refinancing: A Cross-Hedging Paradigm LAURENT L. JACQUE' and PASCAL LANG2 'The Wharton School, University of Pennsylvania, USA and

2Facult6 des Sciences de l'Administration, Universit6 Laval, Canada

Under conditions of chronic exchange rate overshooting and mildly segmented capital markets, optimal currency denomination decision rules for international debt financing are derived for risk-neutral and risk-averse borrowers. For the latter, an inter-temporal expected utility framework yields the risk-adjusted cost of foreign debt, which allows for the pricing of currency cross-hedging effects in multi-currency debt portfolios, artificial currency unit-denominated debt instruments as well as currency swaps.

Key words: banking, decision, finance, risk, stochastic

INTRODUCTION

As economic agents (public and corporate entities alike) gain a more global outlook, foreign currency denominated debt instruments become an integral part of their financing options. In a world of 'mildly' segmented capital markets, where exchange rates 'overshooting', credit rationing with interest-rate ceilings, and 'crowding out' effects by public borrowers is generally the norm rather than the exception, the issue of optimal currency denomination assumes real operational significance. This is in clear contrast with a world of perfectly efficient exchange markets and integrated capital markets, in which optimal currency denomination decisions become a matter of indifference since nominal interest rates reflect inflation rates expectations, which, in turn, determine the future spot exchange rate adjustment path.

Accordingly, this article develops decision-making models to assist borrowers in their decisions as to the currency or currencies in which to issue debt. Specifically, a dichotomy is drawn between publicly-held domestic or multinational corporations (whose shareholders are arguably well diversified in a portfolio wealth sense), which can rely on an expected cost decision criterion (first section), and municipalities, states, government-owned corporations, or privately-held corporations nearing conditions of bankruptcy, etc., which are better off assessing the cost of foreign debt on a risk-adjusted basis (second section). For the latter, an inter-temporal multi-currency expected utility framework allows for the consistent pricing of currency cross-hedging effects in international debt portfolios, artificial currency unit-denominated debt instruments as well as currency swaps.

EXPECTED COST OF FOREIGN CURRENCY FINANCING

For firms whose shareholders are well diversified in a portfolio sense, the expected cost of long-term debt is a legitimate decision criterion, as foreign exchange risk is considered as largely diversifiable (unsystematic) risk. This section thus explores some of the implications of extending the International Fisher Effect Theorem to a multi-period framework in which the borrower services its foreign currency denominated debt by paying interest at the end of each period and the principal at the maturity of the financing horizon at prevailing exchange rates. Tax factors, flotation costs and the use of long-term forward contract or currency swaps as alternatives to debt refunding are introduced sequentially.

O.RS. 38/2-E 1 7 3



Journal of the Operational Research Society Vol. 38, No. 2

The effective cost of straight foreign debt

Consider the case of a US-based entity comparing the cost of borrowing long-term for T years in US dollars at the rate of id with foreign currency at the rate of if. With the latter financing option at the end of each year t, interest has to be paid at the then prevailing exchange rate S(t), defined as the dollar price of one unit of foreign currency. Thus, for each dollar equivalent of borrowed funds 1/S(t), if is the interest rate which must be paid, and this amount of foreign exchange must be bought on the foreign exchange market at the rate of S(t). Hence, the dollar cost of servicing the foreign debt in year t is [1/S(0)] ifS(t), whereas the dollar amount needed to repay the principal at maturity T is [1/S(O)] 1 S(T).

More generally, the effective interest rate on foreign currency borrowing is that rate r which equates one dollar of borrowing proceeds to the present value of all future debt service payments:

T S(t)if S(T)1 (1) 1=Z S(O)(1 + r)+ S(O)(1 + r)T

Implicit in the resolution of equation (1) is the availability of point estimates of future exchange rates S(t). With the exception of Wharton Econometric Forecasting Associates, all forecasters have shied away and for good reasons from generating long-term exchange rates forecasts. This is probably why corporate treasurers tend to be sceptical of point estimates of long-term forecasts in a market where so many have been wrong so often, and prefer to posit a constant annual average rate of appreciation/depreciation a for the exchange rate. Accordingly, let

S(t + 1) = S(t)(1 + x) or S(t) = S(O)(1 + L)',

and substituting the above in equation (1), T jf(I + 0C), (I + C)T(2

(+ r)t +(1 )T* (2)

Solnik and Grall' and Giddy2 have shown that the effective borrowing rate of foreign debt is independent of the maturity of the fixed interest debt, and is indeed the same as for one period:

r =(1 +if)(1 +x)- 1 =if(1 + o)+ . (3)

Simple break-even analysis will assist the borrower in deciding between domestic financing at the coupon rate of id vs foreign financing at the effective interest rate of (1 + if)(1 + aX) - 1; the break-even rate exchange rate change ae* is thus given by:

id = (I + if)(1 + o)- I or a* = l + -1. (4)

If nominal interest rate on foreign debt is less than on domestic debt, foreign financing will be preferred if a <La *, that is if the rate of appreciation on the foreign currency is less than the interest rate differential, and conversely, domestic financing should be preferred if a >, a*

The effective cost of an equal repayment foreign loan

Next we consider the related case of a foreign loan to be repaid in equal (foreign currency) instalments. Typically, this is the case of mortgage financing offered at concessionary (subsidized) interest rate by exporters of 'big ticket' items such as aircraft, ships or weapon systems. Most industrialized countries offer highly subsidized long-term financing for exporters of 'big ticket items'. Clearly, the heavy hand of governments in export-related long-term financing would typically mean that the international parity conditions presumed to hold in the case of well integrated capital markets would never hold for this kind of financing thus the need to develop an analytical framework, as attempted in this paper.

The standard expression for the amount M to be repaid in each year on a one dollar loan for T years at the interest rate of if is

(1 +4i)T 1 5a

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L. L. Jacque and P. Lang Long-term Debt Financing and Refinancing

Since each payment will have to be converted into the foreign currency at the prevailing exchange rate S(t), the effective rate of interest is again found by equating one dollar of borrowing proceeds to the sum of present values of all debt service payments:

if(l + if)T } T (1 + r)t

This ominous equation has a deceptively simple solution, as shown by Giddy,2 which happens to be the same as the corresponding formula for a regular one-period loan:

r = (1 + a)(1 + if) - 1. (4 repeated and 5c)

Thus, when a loan is repaid in a schedule of equal instalments instead of a lump sum or 'balloon' repayment schedule, the effective cost of foreign borrowing under conditions of a steady annual rate a of appreciation/depreciation in the exchange rate remains equal to that of a one-period loan. The effective cost of foreign debt financing given by (4a) or (5c) is independent of the maturity of the loan or the form of repayment.

The impact of taxation

Because tax rates on interest payments and capital gains/losses differ among countries and because tax status differ among borrowers, the effective cost of foreign debt should carefully reflect the tax situation of the borrower. Equations (2) and (5b) can be adapted to specific tax situations, and break-even analysis carried out through numerical analysis as the asymmetry of tax treatment under hypothesis of exchange rate appreciation and depreciation precludes closed-form solutions, as shown by Shapiro.3 Generally, three polar cases will characterize most situations:

(a) Exchange losses on the principal of a foreign currency debt are not tax-deductible, as in England: domestic financing will be favoured (sterling in this case) as long as the foreign currency is expected to appreciate.

(b) By contrast, the tax laws in some countries, such as Sweden, encourage domestic companies to prefer foreign debt financing (under a scenario of foreign currency appreciation) by permitting unrealized exchange losses on foreign currency debt to be tax-deductible immediately, while taxes on exchange gains are deferred until realized.

(c) The intermediate case-characteristic of the US is to allow the tax-deductibility of exchange losses on principal repayment when realized at the corporate income tax rate, whereas exchange gain will generally be taxable at the lower capital gain rate, which ceteris paribus should favour financing in a weak currency.

Debt refunding

Many firms will decide to prepay or refund their foreign currency denominated debt with domestic currency in order to lessen their exchange losses due to foreign currency revaluations or to take advantage of currency overshooting. Assuming that the International Fisher Effect holds and issuing costs are equal, the decision to refund foreign debt with domestic debt should be perfectly identical on an expected cost basis to the decision to refund the existing-debt with a new issue of foreign debt. Typically, though, market imperfections, prolonged exchange rates overshooting, asymmetry in the tax treatments of exchange losses on early redemption of foreign currency principal, and violations of interest rate parity due to continued credit rationing or interest rate subsidies will force the borrowing firm perennially to consider the debt refinancing option in its global financing strategy.

Straight debt. Formally, if it takes 1 + 0 units of domestic currency at time 0 (with 0 < T in a new bond issue) to generate one unit of domestic currency at the interest rate of id after meeting all flotation and prepayment costs, the effective cost of domestic debt refinancing necessary for refunding the foreign debt is the solution rd to

-1+Ei (lI+rd1)t + (1+rd)'t (6)

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Similarly, the effective cost of not prepaying the foreign debt is the solution rf to

-1 + E (1 +r)TO + (1 ) = ? (7)

whose solution is known to be rf = if(l + x) + a. The decision whether or not to refund the foreign debt instrument at time X is given by simple break-even analysis of rd Q rf, which can be solved through numerical methods.

Two new techniques have recently emerged as alternatives to the cumbersome debt refunding strategy: long-term forward contracts and currency swaps allow the issuer to change the currency denomination of its long-term debt portfolio without incurring the significant transaction costs associated with early redemption of principal and flotation costs.

Currency swaps. By exchanging (swapping) interest payment and principal repayment obligations at a fixed (once-for-all) exchange rate, borrowers can free themselves from a foreign debt obligation without incurring the additional cost of prepayment penalty on the debt issue being retired and flotation costs on the new debt issue.

Currency swaps in the framework of equations (6) and (7) are easy to interpret since they allow the borrower to avoid both prepayment penalties and flotation costs (O = 0) if indeed domestic financing becomes preferable to foreign financing. Equation (7) simplifies itself to

id Z if(I + x) + x- (8).

Long-term forward contracts. Long-term forward contracts will allow the borrower to lock in the domestic currency cost of servicing both principal and interest rate payments on the foreign debt instrument by entering into a series of forward purchase contracts in amount and maturity matching the cash flow associated with the foreign debt instrument. Depending upon the pricing techniques used and typically, in a relatively thin wholesale market, there may be some inconsistencies in the pricing of such instruments the use of forward contracts may prove to be an economical alternative to the debt refunding conundrum.

RISK-ADJUSTED COST OF FOREIGN DEBT FINANCING

When total risk matters as was convincingly argued by Dufey and Srinivasulu4-the expected cost of foreign debt financing is an inadequate decision criterion. Because it ignores the risk attributes of the foreign currency of denomination as well as the risk preferences of the decision-maker, it may bias the decision in favour of foreign debt financing. Indeed, the expected cost criterion is generally consistent with risk-neutral decision-makers rather than risk-averse decision-makers. When foreign exchange risk cannot be diversified away by skilful stock portfolio diversification (as in the case of public borrowers such as state-owned corporations or privately- held companies whose owners are undiversified in a portfolio sense), the use of a risk-adjusted cost of foreign debt is warranted.

This section now relaxes the assumption of risk-neutral decision-makers and reformulates the problem in a multi-period expected-utility theoretic framework. The case of a two-period/ two-currency world is considered, although the results can be readily extended to a T-period/ N-currency world; the framework is then applied to the debt refunding problem. Throughout this section, the analytic results are provided without the lengthy mathematical derivations (otherwise available from the authors) as the emphasis is on the decision-making aspects of the problem.

Currency denomination of debt in a two-currency world

Consider the case of a borrowing agent holding a portfolio of a two-period long-term debt made up of a foreign currency, f denominated debt instrument df(t) and a domestic currency denominated instrument d(t). The agent's net 9ash flow in year t, 2(t), is:

Z(t) = A(t) -d(t) - f(t)df(t),

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L. L. Jacque and P. Lang-Long-term Debt Financing and Refinancing

where

R(t) is the borrower's domestic currency net cash inflow in year t before debt servicing, and follows an additive random walk with known mean

2

R(O) + E v(t)

and time-invariant variance C)2;

d(t) and df(t) are respectively the reference currency and the foreign currency cost of servicing the domestic and foreign debt instruments in period [t - 1, t];

Sf(t) is the random domestic currency price of one unit of foreign currency f at time t assumed to follow a random walk with mean

2

S(O) + E +(t)

and time-invariant incremental variance U2, and with time-invariant incremental covariance q with the domestic stream of revenues R(t).

The risk-adjusted cost of such a portfolio of a two-currency/two-period debt instrument can be expressed as:

H(Z) = (1 + p)R(O) + v(l) + 2pv(2) - df(l)[S(O) + k(1)]

-pdf(2)[S(0) + 4(1) + (2)] - pd(l) - p2d(2)

- ir{a2[df(1)2 + 2pdf(1)df(2) + p2df (2)2

-2q[(1 +p)df(l) + p(l + 2p)df(2)] +w 2[1 +2p + 2p2]}, (9)

where r is the level of risk aversion defining the utility function ascribed to the decision-maker, and p the present value factor.

Ranking composite debt portfolio

The valuation model developed in equation (9) can be readily generalized to the N currencies x T periods case, thus allowing the borrowing agent to compare, on a cardinal scale, alternative financing options as embodied in different portfolios of foreign currency-denominated debt instruments. The general model would be expressed as a function of variance-covariance matrix I (instead of the scalar variance a2) and a covariance vector q instead of a scalar covariance q. Estimating the coefficients of the variance-covariance Z may be achieved with historical exchange rate time-series. The key assumption of stationarity of variance or covariance coefficients remains to be investigated, whereas the normality assumption for the exchange probability distribution model remains at least controversial but central to any multi-dimensional (in the currency space) modelling effort. Any such ranking, however, will be stated as a function of the level of risk aversion r, which, as we know, cannot be objectively determined.

Risk profile debt curves and the financing decision

Risk fundamentally is a subjective concept, and the reader will notice that, so far, we have carefully avoided saying much about the risk-aversion parameter r. Instead we suggest sketching the risk-adjusted cost (certainty-equivalent) of foreign debt against the risk-aversion level r, as illustrated in Figure 1. This graph portrays the cost of risk for all decision-makers as characterized by different levels of risk aversion. It is an objective statement of the risk involved in the sense that all different decision-makers who agree with each other on the joint probability distributions representing the underlying source of risk will obtain the same risk profile curve.

These are some general properties of risk profile debt curves which are useful to comment upon:

(a) The height of risk profile debt curves above r = 0 (where decision-makers are assumed to be risk-neutral) is simply the expected value of the objective function.

(b) The risk profile debt curves will generally intersect at a point Q corresponding to a critical level of risk aversion rc. Clearly the decision-maker needs only to decide whether his/her

177




Risk-adjusted cost of debt

(a) Foreign financing

s *Higher covariance

Domestic financing

A_ I i

l l

'c j6 'cRisk-aversion Level Foreign financing preferred Domestic financing preferred

Risk-adjusted cost of debt

(b) Higher variance 77 *

- Foreign financing

Domestic financing

- - I

Is-~----------- | Domestic financing preferred

l I I I

- c

'c Risk-aversion Level Foreign financing preferred

FIG. 1. (a) Break -even risk -aversion level with higher covariance between domestic revenues and exchange rates. (b) Break-even risk-aversion level with higher variance of exchange rates.

risk preference as a borrower lies below (foreign financing) or above (domestic financing) that critical level. Our framework, however, does not indicate what risk-aversion level is appropriate, but it does offer a conceptually sound yet operationally manageable framework for measuring risk-cost trade-offs from a break-even methodological standpoint.

(c) The financing implications of simple changes in parameter estimates can be easily sketched graphically: (i) a lower expected cost for foreign debt financing will result in a vertical downward shift of the risk profile curve Hf, which will increase the critical level of risk aversion r*, beyond which domestic financing is the preferred option; (ii) a higher anticipated volatility for the currency of foreign debt financing (a2) will increase the risk premium term by rotating outward the foreign debt financing curve Hf, thereby lowering the critical level of risk aversion rc, beyond which domestic financing becomes the preferred option [cf. Figure l(a)]; and (iii) conversely, a higher covariance q between the domestic stream of cash inflows and the exchange rate 3f(t) would reduce the risk premium term associated with foreign financing, thereby rotating upward the risk profit curve -f and increasing the critical level of risk aversion [cf. Figure 1(b)].

Isolating the risk premium term in equation (9), we can solve for the break-even covariance q* which would leave the borrower indifferent between domestic and foreign financing. Indeed, if q > Q , it may very well be that foreign debt financing is cheaper than domestic debt financing on

178




a risk-adjusted cost basis and provides a hedging tool against exchange risk subsumed in the borrower's objective function. This is the cross-hedging effect which often motivates the case of foreign long-term debt financing for domestic borrowers. One simple illustration can help us understand intuitively this seemingly paradoxical conclusion.

Consider the case of a public utility typically generating domestic revenues and incurring domestic expenses-such as Hydro-Quebec, selling a significant percentage of its power to an active exporter to the US market, such as Alcan, the manufacturer of aluminium ingots. Although Hydro-Quebec has no nominal transaction exposure to worry about, it is quite clear that a weak Canadian dollar would tend to boost Alcan's exports to the US market and indirectly Hydro- Quebec's profitability. An appreciating Canadian dollar would have the opposite effect. Thus, for Hydro-Quebec, financing part of its capital requirements in US rather than Canadian dollars would cushion its debt-servicing burden and smooth its overall profitability. (For an elaboration of this concept of economic exposure to foreign exchange risk, the reader is referred to Hodder,5 as well as Adler and Dumas.6)

Debt financing in artificial currency units (currency cocktails)

The era of floating exchange rates has witnessed a multiplication of artificial currency units (commonly known as "currency cocktails"), which have been used, among other things, for denominating long-term debt issues. The rationale is simple: by borrowing in a once-for-all fixed portfolio of currencies, the borrower (as well as the lender) expects to hedge in a somewhat indeterminate currency portfolio diversification sense-against excessive single currency fluctuations. The framework introduced in the second section of this article lends itself readily to the certainty-equivalent valuation of a debt instrument denominated in an artificial currency unit (ACU). Recall that an ACU would be valued in the domestic currency of the borrower as:

K

SAcU(0)= E ak-SA(O) with K < N, (10) k = I

where ak is the number of units of currency k included in one artificial currency. Let DACU be the known debt servicing requirement associated with borrowing in ACUs rather than in a home-made portfolio DP. Borrowing portfolios DACU vs Dp can readily be compared in the context of our model by substituting in the debt vector d(t) the corresponding number of units of currency k, ak for the amount borrowed in currency k, dk(t). Since, typically, the interest rate on artificial currency unit-denominated bonds tends to follow closely a currency-weighted interest rate and therefore to ignore the cross-hedging effect of such multiple currency denomination, our portfolio model will assist the potential borrower in valuing correctly the diversification effect imbedded in such debt instruments. Ultimately the borrower will compare the significant savings in flotation costs resulting from one artificial currency unit debt instrument with the multiple flotation costs associated with a 'home-made' diversified portfolio of a single currency denominated debt instrument. Such savings in flotation costs should then be compared with the cost of paying for potential redundant currency diversification. Clearly, the flexibility of refunding a single debt instrument di would be lost under an exclusive ACU borrowing strategy.

A good illustration of the above is the encouragement given by the European Economic Community to float debt in ECUs rather than a single currency. Such state-owned utility companies as Gaz de France or Electricite de France may be simply overpaying by sourcing long-term financing needs in ECUs rather than sterling, DM, DG, etc. It is not clear that these borrowers have explored the true cost of such redundant currency diversification.

Optimal debt portfolios The discussion of the foreign debt financing decision was limited to the ranking on a risk-adjusted

basis of alternative foreign currency denominated debt portfolios. The structure of the general model introduced in the second section is rich enough to allow for a resolution of the optimal debt portfolio problem where N + 1 debt financing instruments are available. Specifically, three questions can be addressed:

179




(a) Given an additional need for debt financing ADp (in domestic currency terms) and an existing portfolio of foreign debt instruments DP, how should the financing be allocated among the N + 1 debt instruments available (assumption of increasing financing needs)?

(b) Given an existing debt portfolio DP, how should maturing debt instrument di be refinanced (assumption of constant financing needs)?

(c) Given an existing debt portfolio Dp(t) structured at time - < t, should debt refinancing be considered?

All three cases are highly representative of public borrowers' predicament (at the state, city, municipal, public utility or government-owned corporations level) and amount to a constrained optimization problem with a quadratic objective function. It is also the major justification for the total risk approach adopted in this section.

The constraints to be imposed on the design of the optimal debt portfolio simply reflect the limited capacity of national capital markets for absorbing large financing needs. Typically (fixed) flotation costs will set the lower bound on the amount to be raised in a single issue in a given capital market, whereas the higher cost of debt beyond a threshold level of borrowing will effectively set a higher bound. Formally, the optimal debt portfolio in an N-currency world would be formulated as:

max 7r(Z) (11) {di

subject to

d, in di < ds.ax

Constrained access to single national capital markets can increasingly be circumvented through a long-term currency swap. The borrower would source long-term financing from the uncon- strained capital market, e.g. US dollar-denominated bonds, and swap its dollar liability for the restricted third currency liability. In addition to interest cost savings, the cross-hedging benefits of sourcing, say, Swiss francs (restricted financing) rather than US dollars (unrestricted financing) would be achieved. In terms of equation (11), the upper bound djnaX would no longer be binding (or binding at a higher level). The framework developed in this paper would clearly assist the borrower in his negotiating the terms of such long-term currency debt swaps.

Additional financing

Given an existing debt portfolio {di(t), I < t -< T, 0 s< i A N} and the need for additional financing, assume that the borrower has identified for each currency iMi 'pure' (re)financing options implying (positive or negative) cash stream changes:

Ad{ = Adf (1),.. ., Ad'(T) with J = 1,..., MI

and i=0,. N.

which is the general case of several financing options in a given currency (either on-shore or off-shore) as call features and/or flotation costs associated with public or private placement will result in different financing costs.

The borrower will, in general, satisfy his additional financing need by considering a mix of these 'pure' options of the form A J AJ {J = 1, . . ., Mi and i = 0, . . ., N} with A J > 0 and EI' o Ej?, IJ < 1. By assessing the expected utility of the revised portfolio(s), the borrower will be able to determine the optimal financing mix by optimizing the function:

f(X) =7tL2 + AZ(1{)] (12)

subject to

180




where A is a vector of dimension

N

E Mi i=O

and the constraint reflects the possible 'crowding out' effect of borrowing in a single national market and therefore limits the extent to which each individual option is to be exercised.

Debt refunding

The problem of debt refunding is somewhat different insofar as a prepayment penalty on refunding a given debt instrument di at time 0 < T (where time T refers to the maturity of debt instrument di) would have to be incorporated in the above constrained optimization problem.

Straight debt. Typically, such debt portfolio revisions will entail significant transaction costs as a function of call premia (as defined in the covenant of the debt instrument to be retired), flotation costs (associated whith the new financing mix), as well as possible higher interest cost during the overlapping period between the time when the new bonds are issued and the old ones refunded. Denoting by /fJ(P{f) the transaction costs incurred from financing di (resulting from either additional financing need or retiring the same amount) through the financing mix Ajdj(t), the borrower will derive the optimal incremental financing portfolio by optimizing the objective function

N M

max{f(A)- E J({f)} (13) i=0 J= I

subject to

N Mi

i=0 J=0

and

AJc {o} . [Jmin, gimax]-

Perold7 discusses solution procedures for similarly-structured problems with disjunctive constraints of the above form, which provides parametric solutions as a function of the risk-aversion parameter r.

Currency swaps. A first alternative to early debt redemption (perhaps prompted by a higher/ lower than expected appreciation of the currency of denomination) is the use of fixed interest rate to fixed interest rate currency swap. By exchanging interest payment and principal repayment obligations at a fixed (once-for-all) exchange rate, borrowers can free themselves from a foreign debt obligation without incurring the additional cost of prepayment penalty and flotation cost on a new debt issue. The framework developed in this section would assist the borrower in negotiating terms that would improve his utility position as well as determine an optimal fraction Asw of the original debt to be redeemed through a swap. The early case of IBM and the World Bank swapping long-term debt in Swiss francs and Deutsche marks for dollars has been followed by a flurry of large transactions, notably the recent swap of a long- term dollar debt for ECU by the French utility company, Gaz de France: for an authoritative study of swap financing, see Antl,8 and for a detailed examination of the World Bank/IBM currency swap, Park.9

Long-term forward contracts. A second alternative to early debt redemption would be to buy the currency forward in amount and maturity matching the debt servicing schedule, as discussed by Beidleman et al.0 Significant prepayment penalty costs can again be avoided. Given offered long-term forward rate, the above framework allows the borrowing agent to derive the optimal percentage ,OF to be covered through a forward contract rather than prepaid. Typically, however, the market for long-term forward contracts (maturities exceeding 24 months) is exceedingly thin, rendering the use of this technique somewhat illusory.

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CONCLUSION

Unexpected exchange rate changes and national financial markets segmentation have turned the market efficiency hypothesis, as applied to the foreign exchange market, into a somewhat dubious operational proposition for international financial management purposes. This article first reviewed the still embryonic body of international financial management theory, which develops simple decision rules based on an expected cost concept of foreign debt financing generally defensible for publicly-held firms whose shareholders are arguably well diversified in a portfolio sense. Secondly, the risk neutrality assumption behind the traditional expected cost criterion used for ranking alternative financing options was relaxed and a risk-adjusted cost of foreign debt formulated when exchange rates obey a random-walk law. This latter approach, based on a concept of total risk, is justified for borrowers such as municipalities, government-owned corporations, etc.

A significant result in the nature of a cross-hedging effect was that a domestic borrower may, on a risk-adjusted basis, prefer foreign financing to domestic financing. In the same vein, the use of artificial currency units, substituted for a portfolio of single national currency, was evaluated from the point of view of mispricing of such debt vehicles, given the redundant diversification imbedded in such instruments. Similarly, the framework was operationalized for debt refunding either directly through actual prepayment of the debt instrument or indirectly through the use of currency swaps and long-term forward contracts.

REFERENCES

1. B. H. SOLNIK and J. GRALL (1975) Eurobonds: determinants of the demand for capital and the international interest rate structure. J. Bank Res. 5, 218-230.

2. I. H. GIDDY (1977) The effective cost of foreign currency borrowing. Unpublished manuscript, University of Chicago. 3. A. C. SHAPIRO (1984) The impact of taxation on the currency-of-denomination decision for long-term borrowing and

lending. J. Int. Bus. Stud. 15, 15-26. 4. G. DUFEY and S. H. SRINIVASULU (1983) The case for corporate management of foreign exchange risk. Fin. Mgmt 12,

54-62. 5. J. HODDER (1982) Exposure to exchange rate movements. J. Int. Econ. 13, 375-386. 6. M. ADLER and B. DUMAS (1984) Exposure to currency risk: definition and measurement. Fin. Mgmt 13, 41-50. 7. A. F. PEROLD (1984) Large-scale portfolio optimization. Mgmt Sci. 30, 1143-1160. 8. B. ANTL (1983) Swap Financing Techniques. Euromoney Publications, London. 9. Y. S. PARK (1984) Currency swaps as a long-term international financing technique. J. Int. Bus. Stud. 15, 47-54.

10. C. BEIDLEMAN, H. L. JOHN and J.A. GREENLEAF (1983) Alternatives in hedging long date contractual foreign exchange exposure. Sloan Mgmt Rev. 24, 45-54.

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currency denomination in long-term debt financing and refinancing: a cross- hedging paradigm

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