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Bling-Bling Corporation Must use IRR function, cannot use ex-post Uncovered Interest Parity, since loan not pure discount arrangement Complication: issue costs Issue cost % applies to the gross financing Gross-up the net financing

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Bling-Bling Corporation Yen cash flows must be forward hedged FX loan: sell loan proceeds at Bid, buy debt service at Ask Criterion: Minimize cost of financing in the reference currency (U$) Technique: determine vector of U$ cash flows, then apply IRR function

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Hedging FX financing cash flows Canuck Avions case: one swap. Bling-Bling case: five forward contracts Bling-Bling must buy JY288,659,794 forward for years 1, 2, 3, 4, 5 and JY7,216,494,880 for year 5. Valid comparison of reference currency vs. FX financing requires that the latter be fully hedged

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Principal Repayment Arrangements 1. Bond-type: pay only interest; at maturity repay entire principal. 2. Mortgage-type: fully amortized with equal annual debt service (blend of interest and principal repayment). 3. Type-3: Principal repaid in equal annual installments; debt service declines during loan life. Ranked from fastest to slowest pace of principal repayment: 3, 2, 1, 0.

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Equal annual repayment of principal (type 3 loan) Borrow $1 at 10% over two years. Principal repayment = 0.5 per year. Interest payments: year1 = $1 x 10% =.1; year2 = $.5 x 10% =.05 Debt service: year1 =.5 +.1 =.6; year2 =.5 +.05 =.55 Cash flows: 1; -.6; -.55. IRR = 10%

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Tabular format for type 3 loan YearPrincipal @Start Principal Repay. Interest Payment Debt Service 11.5.1 = 1(10%).6 2.5.05 =.5(10%).55

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Effect of up-front fee on pace of principal repayment to minimize all-in cost Borrow $1 over 2 years: 10% interest rate, 5% up-front fee Grossed-up principal = 1.05263 = 1/(1-.05) Mortgage-type loan: 1; -0.6065; -0.6065 implies cost = 13.9% Pure-discount bond: 1; 0 ; -1.27368 implies cost = 12.86% Choose slow pace of principal repayment to amortize up- front loan processing fee over longer effective time horizon

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Effects of loan processing fee (F) and FX-denomination SituationPace of Principal Repayment to Reduce Financing Cost Incur F; no FXSlow No F; appreciating FXFast No F; depreciating FXSlow

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Financing in FX If FX is projected to depreciate or exhibits a forward discount, repay principal sloooowly (bond-type is best), other things equal. If FX is projected to appreciate or exhibits a forward premium, perhaps repay principal ASAP (type-3 is perhaps best), other things equal. Why perhaps? In presence of loan processing fees, it is better to postpone principal repayment.

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Covered/Uncovered Interest Parity: Implications High interest rate currency trades at a forward discount and will depreciate. Low interest rate currency trades at a forward premium and will appreciate. The two effects work at cross purposes: one raises, the other lowers the cost of financing in the reference currency. Implication: Apply Excel’s IRR function!

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Dubious Rules of Thumb Definitions: soft currency, likely to depreciate; hard currency, likely to appreciate. Always finance in a soft currency. Problem: such a currency exhibits high interest rate. Always finance in a low interest currency. Problem: such a currency will likely appreciate. Low interest currencies are hard.

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