2011` EXAMINATION QUESTION (6) (6a) What factors do matter in determining the appropriate mix of equity and debt financing for parent and affiliates? (3 marks) 1

2011 EXAMINATION Q & A (6a) Parent’s cost of equity Parent’s after-tax cost of credit Parent’s debt-equity ratio Foreign subsidiary: withholding tax on repatriated proftits, corporate tax Local currency outlook (strength/weakness, possible devaluation/depreciation) Cost of local borrowing by the foreign subsidiary 2

2011 EXAMINATION QUESTION (6) (6 b) Suppose a new foreign investment project in Vietnam requires MYR 100m of which (i) MYR 30m comes from parent co in Malaysia, (ii) MYR 20m from retained earnings of foreign subsidiary in Vietnam, and (iii) MYR 50m in the form of debt financing in the host country. Assume the following: (i) parent’s cost of equity (Kep) is 16%; (ii) parent’s after-tax cost of debt is 6%; (iii) parent’s debt-equity ratio is 30%; (iv) Foreign subs in Vietnam is subject to 8% w-tax on repatriated profits and 40% corporate tax; (v)Local currency of foreign subs (dong) is expected to devalue in the foreseeable future by 7%; and (vi)(vi) local interest rate (in Vietnam) is 20%. Based on the above information, compute the correct “K” (WACC) to be used by parent in discounting the new project. (8 marks) 3

2011 EXAMINATION Q&A (6b) 3 components: (1) Parent’s cost of capital = [Kep (equity ratio) + Kdp (debt ratio) (2) Cost of Subs RE = [Kep (1-withholding tax)] (3) Cost of new foreign debt = [(1 + int rate/1 + likely currency devn)] – 1 x (1- corporate tax) Computation: (1)0.16 (0.7) + 0,06 (0.3) = 0.13 (2)0.16 (1-0.08) = (3)(1.20/1.07) – 1 = x (1-0.4) = Adding weights: 0.30(0.13)+0.20(0.1472)+0.50( = = = 10.5% (WACC) 4

International Finance FN5053/6053 EUROMARKETS LECTURE 11 Part One

EUROMARKETS: DEFINITION Euromarkets – is a term used to describe the network of banks & other financial institutions domiciled in “Europe”, transacting in foreign currency-denominated financial instruments. Euromarkets can be divided into 2 broad categories. Euromarkets Eurocurrency Market Eurobond Market Eurodollar Eurosterling Euroyen etc. Euro -Commercial paper market Euro -FRN (Floating Rate Notes) market Euro – straight bond mkt. 6

EUROMARKETS: CONNECTIVITY In terms of a venn-diagram  with linkages Euro Yen Euro sterling Forex Mkt. US Domestic Market Euro $ bond mkt. Euro $ FRN Mkt. Euro $ - Comm. Paper Mkt. UK Domestic Mkt. Japanese Domestic Mkt. So, the Euromarkets do not operate in isolation but are linked to the major domestic markets of OECD countries. 7

THE EUROCURRENCY MARKET The prefix “Euro” has nothing to do with the currency euro or with Europe! USD deposited in London become Eurodollars. USD on deposit in Toronto or Hong Kong are also Eurodollar deposits. Eurodollar deposits can be placed in a foreign bank or in the foreign branch of a US bank. Eurocurrency market consists of all such banks dubbed as Eurobanks. * Eurobanks accept deposits and make loans in foreign currencies. 8

THE EUROCURRENCY MARKET (cont’d) One does not buy or sell Eurocurrencies: No buying and selling of currencies, just lending and borrowing. The Eurocurrency market involves a chain of deposits and a chain of borrowers and lenders. Most Eurocurrency transactions involve transferring control of deposits from one Eurobank to another Eurobank (inside or outside Europe) The Eurocurrency market operates just like any other financial market, except for the absence of regulations on loans made and interest rates charged. 9

THE EUROCURRENCY MARKETS (cont’d) All Eurocurrency loans are made on a floating-rate basis at a fixed margin above LIBOR (some basis points over and above LIBOR). The said margin varies from as little as 15 basis points to as much as > 300 basis points, depending on the borrower’s perceived riskiness. The maturity of a Eurocurrency loan can vary from roughly 3 to 10 years (8-10 years for prime borrowers). Normally syndicated loans - in which a number of banks participate (the bank originating the loan usually manages the syndicate; in some instances co-managed; syndication fee of 0.25% to 2% of the loan value imposed).

THE EURODOLLAR A Eurodollar is simply a US $ domiciled outside US. Likewise, a Euroyen is Jap.¥ domiciled outside Japan, e.g. in Europe. The way Euromarkets are established, there is very little regulatory enforcement. Since it is US $ traded in London, neither, the Fed. Reserve nor the Bank of England have jurisdiction. For the Fed, it is an offshore transaction, while for the bank of England it is an offshore currency. While the Fed would want to influence their dollars, these “belong” to foreigners and are transacted overseas. 11

THE EUROBOND MARKET The Eurobond market is distinctly different from the Eurocurrency market. Eurobonds are bonds sold outside the countries in whose currencies they are denominated, and these are issued directly by the final borrowers. Banks in the Eurocurrency market (i.e. Eurobanks) act as intermediaries, to transform Eurocurrency deposits into long-term claims on final borrowers: thus, banks place Eurobonds with the final investors. 12

Massive accumulation of USD in Europe (post-war). How did Europe end up with this massive amount of US$s? Marshall Plan – Post WW II the US undertook to reconstruct Europe, Massive amounts of USD were spent in Europe. Much of this currency remained in Europe and didn’t find its way back to US. USD was acceptable currency in many European countries. Until the late 60’s, London was practically the only “global” financial center. The dollars were recycled through London and remained there. Petrodollars – The real boost to Euromarkets was the oil price hike of the early 70’s. The oil price hikes led to a massive transfer of wealth from the West to the OPEC countries, the excess funds flowed back to Europe and added to the dollars already available (note: oil is $ denominated) 13 GENESIS OF EUROMARKETS

EUROMARKETS &THE DOLLAR How the Euromarkets began  started really by the Soviets who needed $ for foreign trade and didn’t want to have their $ reserves in New York for fear for being “frozen” (Cold War). So, the Soviets realized that there was enough $ in Europe to meet all their financing needs. Hence the first true Eurodollar bank  “The Moscow Norodny” began accepting US $ deposits at its London branch and paid interest based on US interest rates. This attracted a lot of deposits, and other banks saw the potential for creating a market in $ in London and elsewhere in Europe. 14

With the success of Eurodollars, the large banks saw that they could use the same concept to create markets in other “international’ currencies, like DM, SFR and JPY. And so, the Eurocurrency Market come to being! The real impetus though was the restrictions and extensive regulations in the US, Germany and Japan. 15 THE EXPANSION OF EUROMARKETS

WHY DO EUROMARKETS EXIST? The Eurocurrency market has thrived for one big reason: government regulation. Banks and suppliers of funds are able to avoid certain regulatory costs and restrictions by going into the Euromarkets: * No reserve requirements * No special charges/taxes on transactions * No mandatory lending to preferred sectors * No interest rate ceilings on deposits/loans * No rules/regulations restricting competition 16

HOW DO THE EUROMARKETS WORK? In the US, the Fed Reserve had (i) Regulation Q  regulating interest rate (int. rate ceiling on deposits), until recently, banks were not allowed to pay interest on checking accounts. Additionally (ii) Regulation M  requires banks to set aside a fraction of their deposits as reserve requirement. Likewise, other central banks like the Bundesbank and Bank of Japan  were even more restrictive. 17

HOW THE EUROMARKETS WORK (cont’d)  Banks can ‘create’ value if there could overcome these restrictions.  Euromarkets allow them to do precisely that. –By being able to pay interest on DD deposits, Eurobanks were able to attract more funds (circumventing Regulation Q) –By not being required to set aside reserve requirements, banks could reduce their cost (circumventing Regulation M)  As is well known, banks can ‘create’ new money or credit. –As to how many times over “the banking system” can expand credit will depend on the money multiplier.  –In its simplest form, the multiplier is Money Multiplier = I Prop. of money SS held as reserves + cash 18

HOW THE EUROMARKETS WORK (cont’d) So, the smaller the proportion required to be kept as reserves, the larger the multiplier: 1/0.04 = 25; 1/0.03 = 33.3 Which really means that the more money a bank can lend out, the higher the aggregate returns (reduce cost  reserves don’t pay interest). Also, the other administrative costs associated with regulations are reduced. Furthermore, the Euromarket is largely a “wholesale market”. 19

HOW THE EUROMARKETS WORK (cont’d)  So, why doesn’t credit expand to infinity? It doesn’t, for several reasons: 1.Banks have to hold some amount of cash to meet withdrawals. 2.“Sovereign risk” – possible (even if unlikely) intervention by the authorities of the jurisdictions where the Eurobanks operate.  3.“Solvency risk” - refusal of central banks to function as “lenders of last resort”. 20

EUROMARKET COSTS The Euromarket spreads (the margin bet. lending and deposit rates) are generally much narrower than the spreads in domestic money markets  Lending rates ( by banks to borrowers) are lower because 1.Lower cost to banks 2.Banks don’t have to give preferential loans to certain sectors as they have to domestically 3.As wholesale markets – most loans are to big COs; low cost of acquiring information about them (also loans are large in size) no reserve requirements no FDIC (Fed Dep Ins Corp) pmts 21

EUROMARKET COSTS (cont’d) Deposit rates are often higher, since: –Rates have to be higher to attract Deposits. –Lower regulatory costs mean banks can compete by offering higher rates (also no reserve requirement). –No interest rate ceilings. So, with competition, banks are willing to pay higher rates. 22

EUROCURRENCY LOANS Eurocurrency* loans are based on floating rates – most common reference rate is the LIBOR – as they involve large amounts over a long period. –This reduces duration constraint  therefore helps banks manage credit risk better. –Duration would equal the reset period (usually 6 months). –At times of high volatility, reset periods can be shorter. Loan Syndication is extensive  helps banks manage credit risk. –Lead bank managers/organizers earn a fee. Multicurrency Clauses : increasingly borrowers can take and repay loans in multiple currencies. Sometimes a borrower can borrow in Eurodollars and repay in multiple currencies. This can give borrowers the option to match outflow currency with inflow currencies. *Recall: Eurocurrency is unrelated to euros; nor is it confined to Europe; USD is the dominant Eurocurrency. 23

EUROCURRENCY LOAN: EXAMPLE Sime Darby, a Malaysian company, borrows EUR 250 million euro-denominated Eurocurrency (Euroeuro) – a syndicated loan led by Credit Suisse and Deutsche Bank with an up-front syndication fee of 2.0%. Net proceeds to Sime Darby: EUR 245 million (after deducting 0.02 x 250 m) Interest rate : LIBOR % (7.25%, reset every 6 months) where LIBOR = 5.5% The 1 st semi-annual debt service payment = EUR 9,062,500 [(0.0725/2) x 250 m]. Sime Darby’s effective annual interest rate for the 1 st six month is 7.40% [(9,062,500/245 m) x 2 x 100]. The annualized cost will change with LIBOR6 every 6 mths. 24

EUROBONDS Eurobonds are bonds sold outside the countries whose currencies they are denominated in. Most of the advantages and regulatory characteristic of Eurocurrency’s apply. However, there are several differences. 25

EUROBONDS (cont’d) COMMON FEATURES EUROBONDS 1.Most Eurobonds have sinking fund requirements esp. if maturity  7 yrs. (Borrower pays sinking fund or fixed amount to retire the bond  sometimes to a trustee bank). 2.Have call provisions  giving borrower (i.e. issuer) the option to redeem the bond earlier. 3.Eurobonds are mostly “bearer-form”: i.e. - do not have to be registered for tax reasons. Whoever holds the bonds gets repaid. (allows anonymity).  esp. tax evasion. *This feature is so important that many companies especially, US Co’s can issue Eurobonds to raise funds much more cheaply. 4.Whereas Eurocurrency loans are almost always floating rate loans, Eurobonds come in both the fixed and floating rate variety. 26

EUROBONDS (cont’d) Sinking Fund requires the borrower to retire a fixed amount of bonds yearly after a specific number of years. In the case of Purchase Fund, bonds are retired only if the market price is below the issue price. The purpose of these Funds is to support the market price of the bonds and to reduce bondholder risk (ensures that not all the firm’s debt will come due at once). Call Provisions give the borrower the option of redeeming/retiring the bonds before maturity, should interest rates decline significantly in the future ( Note: Call Provisions carry a call premium and higher interest rates). 27

EUROBONDS vs. EUROCURRENCY LOANS EUROBONDS Both fixed & floating rates. Longer maturities (20 years?) Huge (often billions of $) Higher floatation costs (roughly 2.25%). Funds must be drawn down in one sum on a fixed date and repaid on fixed schedule. Switching currency is costly. Takes time to raise funds (2- 3months). EUROCURRENCY LOANS Floating rates practically. Relatively shorter maturities. Relatively smaller in size. Lower floatation costs (usually 0.5%). Drawdown can be staggered (fee on used portion) and can be prepaid in whole or in part at any time. Multicurrency clause. Funds raised faster (within 2-3 weeks). 28

EURONOTES Euronotes represent a low-cost substitute for syndicated credits. Borrowers issue their own short-term Euronotes and have them distributed by financial institutions. Also known as “Euro-commercial paper”, but the term Euro-CP is reserved for those Euronotes that are not underwritten. Most Euronotes are USD-denominated with high face values (often $500,000 or more). Euronotes are sold at a discount from face value; the return to investor is the diff. between purchase price and face value. 29

EUROMARKET HIGHLIGHTS Regulatory Freedom Cost Reduction Innovation have been the underlying catalysts for the development of Euromarkets. Since, the early 80’s, the “Asiadollar Market” has developed: based in Singapore, HK and Tokyo  (Vietnam War $). Though still small compared to Eurodollar markets, the Asiadollar market is fast developing. Note: Asiadollar is generically Eurodollar ! 30

ASIACURRENCY & ASIABOND The Asiadollar market was founded 1n 1968, located in Singapore, as a satellite market to channel to and from the Eurodollar market for the large pool of offshore funds circulating in Asia. The Asiabond instrument is called the “dragon bond” Dragon bond is a debt denominated in a foreign currency (usually dollars), but launched, priced and traded in Asia. The first dragon bond was issued in 1991 by ADB. All is not well with dragon bond, as Asian borrowers with good international credit rating can raise money more cheaply in Europe or the United States. 31

FEATURES OF EUROMARKETS Major Participants : *Large commercial and investment banks *Multinational companies *International financial organizations (e.g. IMF). Major Centres : * London *Paris *Brussels *Frankfurt 32

FEATURES OF EUROMARKETS (cont’d) About 75% of Eurobonds have been USD- denominated Other currencies featured in Eurobond issues are EUR, JPY and GBP Eurobond market thrives because it remains largely unregulated and untaxed. Big borrowers like Exxon and IBM can raise money more quickly and more flexibly than they can at home As the interest income is tax free, investors accept lower interest rates than that on treasury bills 33

FEATURES OF EUROMARKETS (cont’d) The Eurocurrency market and the Eurobond market exist because they enable borrowers and lenders to avoid regulations and controls and to escape payment of some taxes. These external markets will survive as long as governments regulate domestic financial market but allow free flow of capital. 34

SUMMARY & CONCLUSIONS Euromarket is a wholesale market. Eurocurrency and Eurobond markets are a response to the restrictions, regulations and costs that governments impose on domestic financial transactions. Globalization of the financial market has made such govt. interventions irrelevant (the use of interest rate swap and currency swap is a case in point) Eurobonds have become a viable alternative to Eurocurrency loans Euronotes are short-term papers issued by the borrowers Euro-CPs are non-underwritten short-term Euronotes Asiacurrency and Asiabond markets are the Asian counterparts to Euromarket 35

LECTURE 11 (Part Two) Interest Rate Derivatives and Currency Swaps 36

Interest Rate Swaps IRS is an agreement between 2 parties to exchange USD interest payments for a specific maturity on a notional amount. The notional principal is just a reference amount for interest calculation (no principal changes hand). Maturities range from 15 years (mostly 2 to 10 years). Two types of IRS: (1) coupon swap and (2) basis swap. LIBOR (London Interbank Offered Rate) is the most important reference rate in swap transactions. 37

Interest Rate Swaps (cont’d) *Coupon Swap: one party pays a fixed rate and the other side pays a floating rate. *Basis Swap: Both parties exchange floating interest payments based on different reference rates 38

Interest Rate Swaps: Example Counterparts A and B require $100 million for a five-year period. To reduce uncertainty, A prefers to borrow at fixed rate, whereas B prefers a floating rate borrowing. Suppose: A has difficulty in raising fixed rate bond at attractive price; but B can borrow at finest rates in either market. For A with BBB rating, the fixed rate available is 8.5%; floating rate available is 6-month LIBOR + 0.5%. For B with AAA rating, the fixed rate available is 7.0%; floating rate available is 6-month LIBOR. A-B fixed rate differential = 1.5% (8.5 – 7.0); A-B floating rate differential = 0.5%. For fixed, the credit quality diff. is worth 150 basis points; for floating, the credit quality diff. is worth only 50 basis points. 39

IRS Example (cont’d) To begin, A takes out a $100 m five-year floating-rate Eurodollar loan from a syndicate of banks at an int. rate of LIBOR + 50 basis pts. At the same time, B issues a $100 m five-year Eurobond with a fixed rate of 7%. A and B then enter into an IRS arrangement with G- Bank. A agrees to pay G-Bank 7.35% for five years. In return, G-Bank agrees to pay A six-month LIBOR (LIBOR6) over five years with dates reset to match the date on its floating-rate loan. Thus, A’s floating-rate loan is turned into a fixed-rate 7.85% ( ). Note that A saves/gains 65 basis points ( )! 40

IRS Example (cont’d) Similarly, B enters into a swap with G-Bank, agreeing to pay six-month LIBOR to G-Bank on a notional principal amount of $100 m for five years in exchange for receiving payments of 7.25%. Thus, B has swapped a fixed-rate for a floating-rate loan at an effective cost of LIBOR6 minus 25 basis points ( ) Cost saving for A = 65 basis points; cost saving for B = 25 basis points; what does G-Bank get? G-Bank receives LIBOR6 from B and pays LIBOR6 to A (cancels out) G-Bank receives 7.35% from A and pays 7.25% to B, gaining 10 basis points (7.35 – 7.25), which translates into $100,000 annually for next five years on the $100 m swap transaction! 41

Currency Swaps A Currency Swap is a transaction in which two parties agree to exchange a fixed amount of one currency for another. The main difference between an interest rate swap (IRS) and a currency swap is that, in an IRS, notional principal is never exchanged. In a currency swap, however, the notional principal in two different currencies is exchanged. A first exchange of the two currencies occurs at the initiation of the swap contract. Typically, this first exchange is based on prevailing spot exchange rates at the time. This initial exchange is then reversed at the end of the swap contract period. Since the amounts exchanged in both periods are exactly the same, exchange rate risk is eliminated. 42

Currency Swaps (cont’d) Technically, a currency swap is an exchange of debt-service obligations denominated in one currency, for the service on debt denominated in another currency. By swapping future cash flow obligations, the two parties replace cash flows denominated in one currency with cash flows in another currency. In a dollar/yen swap, an US firm borrowing yen converts its proceeds into dollars - by swapping its yen obligations for the dollar obligations of a Japanese counterpart. In effect, this is tantamount to the US firm selling fixed amounts of dollars forward for fixed amounts of yen; or the Japanese firm selling fixed amounts of yen forward for fixed amounts of dollars. Thus, the currency swap contract behaves like a long-dated forward exchange contract, in which the forward rate is the current spot rate. 43

Illustration: A Currency Swap Suppose a Malaysian company, MISC, with operations in Japan wishes to expand its warehousing facilities in Yokohama. The cost of the expansion will be 100 million ¥en. Its banker in Japan, The Bank of Tokyo is willing to provide the financing on the following terms: Principal Amount= ¥en 100 million Loan Tenor= 5 years Interest= fixed 5%; (¥en 5 million) payable annually on 31st Dec. Principal to be repaid in one lump sum at end of 5th year Now suppose, Matsushita, a Japanese firm with operations in Malaysia wants to expand its facilities in Malaysia. The estimated cost of the expansion is RM10 million. Matsushita’s banker in Malaysia, Maybank is willing to provide a RM10 million loan on the following terms: Principal Amount= RM10 million Loan Tenor= 5 years Interest= fixed 8%; (RM800,000) payable annually on 31st Dec. Principal to be repaid in one lump sum at end of 5th year If each firm takes the loan being offered without doing anything more, they face exchange rate risk on both the principal amount and the annual interest payments. If the currency they borrow in appreciates against their home currency, their effective cost increases. Additionally, since each firm’s revenues are mostly in their respective home currency, having a large foreign currency denominated obligation causes a currency mismatch. 44

Currency Swap (cont’d) To avoid these problems, both MISC and Matsushita could take the foreign currency loans they are being offered and then enter into a currency swap in order to overcome the exchange rate risk. To see how the swap can be structured, assume that the spot exchange rate between the ¥en and the Ringgit is 10 ¥en per Ringgit. To lock-in the prevailing exchange rate and avoid currency risk on both the principal and interest payments over the next 5 years, they can undertake the swap as follows. MISC takes the loan principal of 100 million ¥en from The Bank of Tokyo and forwards it to Matsushita, which in turn gives MISC the RM10 million it received from Maybank. These principal amounts are reversed at the end of the 5th year. In addition, at the end of each year, MISC gives Matsushita RM800,000 being 8% interest on RM10 illion to Matsushita which in turn gives MISC ¥en 5 million as (5%) interest on the ¥en loan. Each company simply passes on the payments received to their respective banks as fulfillment of their obligation. 45

Mechanics of A Currency Swap Ringgit / ¥ en Currency Swap Bank of TokyoMISC MatsushitaMaybank 0  ¥ en 100 Mil. Year ¥en 100 Mil. RM 10 Mil. Year RM 10 Mil. 00 0  0 1  ¥en 5 Mil. 1  RM800K ¥ 5 Mil  1 RM800K  1 2  ¥en 5 Mil. 2  RM800K ¥ 5 Mil  2 RM800K  2 3  ¥en 5 Mil. 3  RM800K ¥ 5 Mil  3 RM800K  3 4  ¥en 5 Mil. 4  RM800K ¥ 5 Mil  4 RM800K  4 55 ¥en 5 Mil. 5  RM800K ¥ 5 Mil  5 RM800K  5 55 ¥en 100 Mil. 5  RM 10 Mil. ¥ en 100 Mil.  5 RM10 Mil.  5 46

Cost of Currency Swaps In the illustration, both parties protect themselves from exchange rate risk by swapping their home currencies with no reference to forward rates or future spot rates. It is in this sense that currency swap is equivalent to a long-dated forward exchange contract, in which the forward rate is the current spot rate. Note that interest rate in the preceding illustration is 5% in Japan and 8% in Malaysia. This means that one party will pay 8% and receive 300 basis points less. This is the “price” one pays for the currency swap arrangement, which adjusts to compensate for the differential between the spot rate and long-term forward rates. 47

Cost of Currency Swaps (cont’d) Recall that forward rates are a direct function of the interest rate differential for the two currencies involved (interest rate parity theory). Therefore, a currency with a lower interest rate has a correspondingly higher forward exchange value, as is the case with the yen in the illustration. This means that JPY is at a premium and that MYR is at a discount in the forward market. MISC pays 8% interest on behalf of Matsushita, while the latter pays 5% interest on behalf of MISC – which suggests a forward spread of 3% in favour of yen. Why then currency swap, not forward hedge? The answer is simple: No forward hedge is available for a five-year period! 48

Summary & Conclusions Interest and currency swaps represent financial transactions in which 2 counterparties agree to exchange streams of payments over time - so as to lower their cost of funds. In IRS, no actual principal is exchanged, but interest payment streams are exchanged. “Coupon swaps” refer to swaps from fixed to floating rate. “Basis swaps” refer to swaps from one reference floating rate to another reference floating rate. In currency swaps, notional principal is exchanged in the beginning and reversed at the end of the contract. 49

Summary & Conclusions (cont’d) Currency swap refers to transaction in which 2 parties exchange specific amounts of 2 currencies at the outset and repay over time according to a pre- determined rule that reflects both interest payments and amortization of principal. Currency swap can help manage both interest rate and exchange rate risks. Currency swap behaves like a long-dated forward foreign exchange contract, in which the forward rate is the current spot rate. Interest rate differential is the implicit forward premium/discount. 50

2011 EXAMINATION QUESTION (5) (a)“The currency swap contract behaves like a long- dated forward foreign exchange contract, in which the forward rate is the current spot rate”. Explain. (3 marks) (a)Illustrate with a hypothetical example how a currency swap arrangement can work for the benefit of both parties. (8 marks) 51

END OF LECTURE 11 TAKE CARE! 52