Treasury, Foreign Exchange, and Financialization - Essay Example

?573082 TFEF Treasury, Foreign Exchange and Financialization Number Reference: TFF/GLOBAL Accelerator/2 Number of words: 1629 Part I would advise Columbia River Pulp Company Inc. (CRP) to choose the swap option. In addition to providing a level of certainty for CRP, this option has proved to be the cheapest option for the company when compared to the interest rate cap and collar options. The table below which is labeled – Table 1 shows the principal repayments schedule for the $200mn facility provided by Toronto Dominion Bank (TD). These were used as a basis for calculating the interest payments in the appendix. CRP Loan Principal Repayment Schedule Date Principal Repayment Balance Jul-88 200,000,000 0 200,000,000 Oct-88 200,000,000 3500000 196,500,000 Dec-88 196,500,000 11,025,000 185,475,000 Jan-89 185,475,000 3500000 181,975,000 Apr-89 181,975,000 3500000 178,475,000 Jul-89 178,475,000 3500000 174,975,000 Oct-89 174,975,000 3500000 171,475,000 Dec-89 171,475,000 19,923,000 151,552,000 Jan-90 151,552,000 3500000 148,052,000 Apr-90 148,052,000 3500000 144,552,000 Jul-90 144,552,000 3500000 141,052,000 Oct-90 141,052,000 3500000 137,552,000 Dec-90 137,552,000 11,798,000 125,754,000 Jan-91 125,754,000 3500000 122,254,000 Apr-91 122,254,000 3500000 118,754,000 Jul-91 118,754,000 3500000 115,254,000 Oct-91 115,254,000 3500000 111,754,000 Dec-91 111,754,000 11,604,000 100,150,000 Jan-92 111,754,000 3500000 108,254,000 Apr-92 108,254,000 3500000 104,754,000 Jul-92 104,754,000 3500000 101,254,000 Oct-92 101,254,000 3500000 97,754,000 Dec-92 97,754,000 23,145,000 74,609,000 Jan-93 74,609,000 3500000 71,109,000 Apr-93 71,109,000 3500000 67,609,000 Jul-93 67,609,000 3500000 64,109,000 Oct-93 64,109,000 10000000 54,109,000 Dec-93 54,109,000 16,505,000 37,604,000 Jan-94 37,604,000 10000000 27,604,000 Apr-94 27,604,000 10000000 17,604,000 Jul-94 17,604,000 10000000 7,604,000 Oct-94 7,604,000 10000000 -2,396,000 Table 1 The principal repayment schedule in Table 1 takes into consideration the fact that the loan principal repayment would start one quarter after the 21st of July 1988 and for that reason the repayments are a little different from Exhibit 6 in the case. All payments made in December relate to advance payments which are made 120 days before the fiscal year end. This has resulted in a difference of $2.4m in overpayment. These repayments were used as a basis in calculating the interest payments in the appendix. The table in the appendix shows the most likely scenario, a high interest scenario and a low interest scenario for CRP as a basis for deciding which of the three hedging strategies is most favorable. The interest payments on the swap option were calculated semi-annually in keeping with the requirements of that option. The interest rates used to calculate the quarterly interest payments were adjusted to reflect the effects on the interest paid interest on the loan by the corresponding hedging strategy. Therefore, the information does not reflect whether CRP or the other party gained from the interest rate swap, interest rate cap or the interest rate collar hedging strategies. The aim of the schedule is to determine which hedging strategy provided the best option in terms of being the least expensive for CRP. The table in the appendix shows the interest payments on the $200mn loan under the three hedging strategies and for each scenario. Most likely scenario Table 2 indicates that under the most likely scenario the interest rate swap option provides the best hedging alternative with a required interest payment of $53.7mn and an average interest rate of 11.31% for the three year period (interest remaining fixed throughout the period). This compares favorably with a required interest payment of $59mn and an average interest rate of 11.65% on the interest rate cap option. The interest payment required on the interest rate collar option is $59.6mn with an average interest rate of 11.77%. The loan agreement indicates that the interest rate charged on the hedging instrument should not exceed 12% which implies that the interest rate collar option could not reasonably be considered without breaching the loan agreement with Toronto Dominion Bank (TD). The interest rate cap option under this scenario may appear to be a little better than the interest rate collar option based on the calculations shown in the table. However, there are some additional charges which would have to be paid up-front. On a $200mn loan this charge would amount to $2mn if a 10% interest rate cap is used. This additional charge would make it much less attractive than the interest rate collar option. Andrew has already indicated that CRP would not be able to pay that money and so that alternative is highly unlikely. The principal balance in the table shown in the table in the appendix was calculated based on the repayment schedule worked out in Table 1. Lower interest rate scenario The interest rates chosen for lower interest rate scenario which is shown in the table in the appendix are 50 basis points less than that used in the most likely scenario. Table 2 also indicates that the interest rate swap option was more favorable than the other two options with the lowest interest payment of $53.6mn required as well as the lowest overall average interest rate of 11.31% for the three year period. The interest rate collar option shows the highest interest payment of $58.1mn and an average interest rate of 11.44% for the period. The interest rate cap option is just over $0.63mn less than the interest rate collar option and so the additional $2mn charge is still a factor that makes the interest rate cap option unfavorable even if CRP was willing and able to make that up-front payment it cost $1.37mn more than the interest rate collar option. The interest payments used in Table 2 are based on the principal repayment schedule in Table 1. High interest rate scenario The interest rate chosen for the high interest rate scenario which is shown in table in the is 1% or 100 basis points higher than the most likely scenario. As is expected based on the results of the most likely scenario, and with the interest on the swap option remaining fixed, it still provides the best alternative for CRP. The information in the table also indicates that the difference of approximately $0.55mn between the interest rate collar and the interest rate cap option still cannot compensate for the initial cost on the interest rate cap option of $2mn. The interest payments used in the calculations are based on the principal repayment schedule shown in the appendix. In addition to providing information on the expected outcome for each of the interest rate hedging options, Table 2 also summarizes the information shown in the appendix. Summary of Interest Rate Options Based on Three Possible Scenarios Options and Scenarios Probability Interest Payment Expected Swap Option     53,573,095 Highest Interest Rate 25% 53,573,095   Most Likely Interest Rate 50% 53,573,095   Lowest Interest Rate 25% 53,573,095   Cap Option     59,019,834 Highest Interest Rate 25% 60,677,600   Most Likely Interest Rate 50% 59,017,804   Lowest Interest Rate 25% 57,366,129   Collar Option     59,662,125 Highest Interest Rate 25% 58,063,677   Most Likely Interest Rate 50% 59,630,370   Lowest Interest Rate 25% 61,324,081   Table 2 Table 2 shows the probabilities of each of the scenarios under each hedging strategy and provides information on the expected interest payment that is applicable. The information emphasizes the fact that the swap option is most favorable. The $2mn additional payment required for the cap option makes it the least favorable of the three options. However, Madura (2006, p. 457) points out that participants engaged in interest rate swaps can be exposed to basis risk, credit risk and sovereign risk. Basis risk does not allow the swap user to completely eliminate exposure to interest rate risk. Additionally, the counterparty on a swap agreement may not meet payment obligations. This is described as credit risk. Sovereign risk points to the possibility that the counterparty may not be able to meet obligations because of political considerations (Madura 2007). Part 2 CRP should hedge the full amount of the loan for the first three years. As the economic situation improves CRP could decide whether or not to continue with the swap option or possibly look at the collar option. It is expected that by that time interest rates maybe significantly less, thus allowing the company the opportunity to seek alternative options of hedging interest rates. Based on the financial projections CRP should have sufficient funds to be able to comfortably pay the interest required as shown by the calculations in the income and balance sheet projections in Exhibit 4. The Chairman of CRP has provided information which indicates that interest rates are trending down while TD indicates a somewhat different picture based on the information in Exhibit 5. It is important that CRP continue to look at the economic indicators before deciding to enter into an agreement for a longer term hedging of its interest rate. CRP may choose between a passive hedging strategy which seeks to reduce risk or an active hedging strategy which seeks to manage risk. By managing risk the company the amount of losses on the company’s loan portfolio is minimized. If CRP believes that interest rates will rise in the long run then it is best to increase the life of the loan and hedge using the interest rate option over the life of the loan which is seven years. If on the other hand CRP believes that the interest rates will decline then it would be best to adopt a wait an see attitude as indicated above. Part 3 According to Eiteman et al (2007) in accordance with a firm’s objective of shareholder maximization, the firm can strive to increase shareholder value as measured by the sum of capital gains and dividends. It is possible to use hedging strategies to minimize the risk of increased interest costs at CRP. Hedging removes the company’s exposure to interest rate risks which could result in serious consequences for the company. According to Nawalkha and Soto (2008) increases in interest rates may result in a significant level of erosion in the value of equity. This provides a level of certainty for shareholders as this information will be incorporated in the price of CRP shares on the stock market. The certainties relating to CRP interest rates may lead to investors being attracted to its shares. Additionally, the company may be able to obtain cheaper loans in the future. Reduced interest cost can also facilitate increased dividend payments because of the impact that the reduction or the stability of interest costs can have on the operating profit of the company. This would lead to increased distribution in the form of dividends to shareholders. It can also lead to an increased in retained earnings which has a positive impact on shareholders’ equity interest in the company. If the market is efficient, shareholders will therefore be able to benefit from both the increased dividends as well as an increase in the stock price. Appendix Comparison of the Cost of Hedging Instruments Most Likely Scenario                             Aug-88 Nov-88 Feb-89 May-89 Aug-89 Nov-89 Feb-90 May-90 Aug-90 Nov-90 Feb-91 May-91 Aug-91 Average interest/Total Interest Expense LIBOR (%) 8.50 9.00 9.50 10.00 10.50 11.00 10.75 10.50 10.25 10.00 9.75 9.50 9.25   Market rate 10.5 11 11.5 12 12.5 13 12.75 12.5 12.25 12 11.75 11.5 11.25   Principal 200,000,000 196,550,000 181,975,000 178,475,000 174,975,000 171,475,000 148,052,000 144,552,000 141,052,000 137,552,000 122,254,000 118,754,000 115,254,000   Swap rate 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 Interest   11114902.5   10092761.3   9696911.25   8174415.6   7778565.6   6715538.7   53,573,095 Cap rate 10% 10.50 11.00 11.50 12.00 12.00 12.00 12.00 12.00 12.00 12.00 11.75 11.50 11.25 11.65 Interest 5250000 5405125 5231781 5354250 5249250 5144250 4441560 4336560 4231560 4126560 3591211 3414178 3241519 59017804 Collar rate 10.75 11.00 11.50 12.00 12.25 12.25 12.25 12.25 12.25 12.00 11.75 11.50 11.25 11.77 Interest 5375000 5405125 5231781 5354250 5358609 5251422 4534093 4426905 4319718 4126560 3591211 3414178 3241519 59630370 Lower Rate Scenario                           LIBOR (%) 8.00 8.50 9.00 9.50 10.00 10.50 10.25 10.00 9.75 9.50 9.25 9.00 8.75   Market rate 10.00 11.50 11.00 11.50 12.00 12.50 12.25 12.00 11.75 11.50 11.25 11.00 10.75   Principal 200,000,000 196,550,000 181,975,000 178,475,000 174,975,000 171,475,000 148,052,000 144,552,000 141,052,000 137,552,000 122,254,000 118,754,000 115,254,000   Swap rate 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 Interest   11114903   10092761   9696911   8174416   7778566   6715539   53573095 Cap rate 10% 10.00 10.50 11.00 11.50 12.00 12.00 12.00 12.00 11.75 11.50 11.25 11.00 10.75 11.33 Interest 5000000 5159438 5004313 5131156 5249250 5144250 4441560 4336560 4143403 3954620 3438394 3265735 3097451 57366129 Collar rate 10.75 10.75 11.00 11.50 12.00 12.25 12.25 12.00 11.75 11.50 11.25 11.00 10.75 11.44 Interest 5375000 5282281 5004313 5131156 5249250 5251422 4534093 4336560 4143403 3954620 3438394 3265735 3097451 58063677 Higher Rate Scenario                           LIBOR (%) 9.50 10.00 10.50 11.00 11.50 12.00 11.75 11.50 11.25 11.00 10.75 10.50 10.25 Market rate 11.50 12.00 12.50 13.00 13.50 14.00 13.75 13.50 13.25 13.00 12.75 12.50 12.25 Principal 200,000,000 196,550,000 181,975,000 178,475,000 174,975,000 171,475,000 148,052,000 144,552,000 141,052,000 137,552,000 122,254,000 118,754,000 115,254,000 Swap rate 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 11.31 Interest   11114903   10092761   9696911   8174416   7778566   6715539   53573095 Cap rate 10 11.50 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 11.96 Interest 5750000 5896500 5459250 5354250 5249250 5144250 4441560 4336560 4231560 4126560 3667620 3562620 3457620 60677600 Collar rate 10.75 12.00 12.25 12.25 12.25 12.25 12.25 12.25 12.25 12.25 12.25 12.25 12.25 12.12 Interest 5375000 5896500 5572984 5465797 5358609 5251422 4534093 4426905 4319718 4212530 3744029 3636841 3529654 61324081 References Eiteman, D.K., Stonehill, A.I and Moffett, M.H. (2007). Multinational Business Finance. 11th ed. USA: Pearson/Addison Wesley Madura, J. (2006). Financial Markets and institutions. 7th ed. USA: Thomson South Western Nawalkha, S.K and Soto, G.M. (2008). Multifactor Models for Managing Interest Rate Risk. Retrieved from: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1264282. [Accessed 24th Sept 2011] Read More