Case Analysis: Gaz de France - Essay Example

Teacher Case Analysis: Gaz de France ANSWER TO QUESTION The economic indices for France illustrated in the Exhibit 5 present eight different parameters. The GDP, among these parameters, barely play a role in the currency exchange market. Current account balance is a factor that influences the exchange rate. The decrease in the current account balance increases demand of the foreign currency causing depreciation of the local currency. An increase causes an appreciation of the local currency. The foreign exchange reserves allow the government to intervene any volatile situation in the currency exchange market. The interest rate also plays an important role. The prevalent interest of FF against USD will influence FF-USD forward exchange rate. The government budget also plays a role in the exchange market; a deficit in the budget increases foreign currency demand. Among listed parameters; account balance, foreign exchange reserves and government budget are considered as the core parameters. ANSWER TO QUESTION 2. The attached figure illustrates current account balance and foreign exchange reserves for the period from 1980 to the 1st quarter of 1986. Both account balance, and foreign reserves decreased during years from 1980 to 1982. It would depreciate FF against USD, which is also confirmed by the increase in the deficit of the government budget. During the years from 1982 through 1985, an increase in the current account and foreign reserves were observed; however, the budget deficit during the same time kept increasing. This trend would further depreciate the French Franc. Budget deficit considerably decreased in the 1st quarter of 1986 with respect to 1985; this will appreciate the Franc. A combined analysis of trend of account balance, foreign reserve and budget deficit explains that depreciation rate will be substantial during the years from 1980 through 1984, which will slow down in 1985 demonstrating further appreciation of FF in the subsequent year with respect to the previous years. ANSWER TO QUESTION 3. The exchange rate between two currencies is influenced by various parameters. This assignment has selected three parameters; current account, foreign exchange reserves and government budget. The set forth above section presented a forecast of the behavior of the FF-USD exchange rate. The attached graph displays the movement of the real exchange rate for years from 1980 to the 1st quarter of 1986, which confirms the forecasted behavior. The FF depreciated from 1980 to 1982 because all three parameters; budget, balance and reserve show decrease in values from 1980 through 1982. The current balance and reserves showed an in increase from 1982 to 1985, but the budget deficit showed a decrease during the same period. Even though, current balance is the determinant factor, but the budget deficit pushed the exchange rate downwards. A graphical presentation of the rate of depreciation and appreciation confirms that in this case, the budget deficit played a significant role exchange rate behavior. ANSWER TO QUESTION 4. Gaz de France acquired foreign debt through the issuance of bonds in foreign currency. It implies that the Company had to pay interest in foreign currency. An unfavorable exchange rate was observed by the end of 1981 that led to believe further devaluation of FF. It became apparent that interest payment would be substantial in the subsequent years. The Company opted to engage in Swaps and Forward contracts. By engaging in these activities, the Company ensured the inflow of a predetermined or fixed amount of USD for a fixed prearranged payment terms in Franc. It would limit the risk of variable interest payment due to the fluctuation of the exchange rate. ANSWER TO QUESTION 5 The risk, in this case, is the volatile exchange rate that could force Gaz de France spend every time more local currencies for the payment of interest in USD. Let us consider that in 1981, the Company issued five-year dominated $1 million bonds with an interest payment of 10% of the face value. Hence, the total interest at the end of the years is $100,000,000. The exchange rate at the beginning of 1981 was 4.22 (FF/USD) and in the end it was 5.41. Let us consider that at the beginning of the year, the Company enters into a forward contract at 4.5 rates. It implies that the company will have to pay FF 450,000 instead of FF 541,000 to meet its interest payment obligation. Let us further assume that the year-end exchange rate was lower than 4.5. In that case, company can purchase $1,000,000 in the open market to meet its obligation. The forward contract does not constitute an obligation. Thus, by entering into a forward contract, the Company reduces the risk (Pinaskovitch 1). The following table illustrates the above review. Face value of debt $100,000,000 Analysis: Scenario with or without Forward Contract Term 1981-1986 Coupon rate 10% Annual interest at the year end $100,000 Scenario with Forward Contract Scenario without Forward Contract Term End of 1981   Term end of the year   Predetermined exchange rate 4.5 Actual exchange rate 5.4 Total payments in FF 4,500,000 Total payments in FF 5,400,000 Potential Gain from the forward contract = 5,400,000 - 4,500,000 = 90,000 FF ANSWER TO QUESTION 6. One of the ways to gain from fixed rate swap is to offset the original swap at a later date. GDF with reverse swap option, a year after the original swap can take the advantage of the depreciation in the FF/USD rate to convert the discounted future payments in FF at a higher rate. The FF/USD rate during years from 1983-1985 has depreciated; therefore, in the absolute value it represents devaluation. In the reverse swap, a large principle amount of FF will pay the same amount of USD in the future while enjoying higher interest rates. Offsetting the original swap and taking the opportunity of the currency depreciation, GDF gets more local currency after paying the same amount of dollars. The net gain / loss is obtained by discounting the incremental cash flows. Thus, the fixed currency swap may bring gains of more than FF1 billion. ANSWER TO QUESTION 7 The swap and forward contracts are essentially equal to betting. By entering into this betting, GDF entered into high levels of market and credit risks. When a prominent organization enters into similar risk, it creates negative market sentiment. The same happened with respect to the peer company like GDF. At the same time, analysts were suggesting an evident appreciation of Franc in the near future. Therefore, initiated by GDF swap and forward contract activities could bring huge losses. Furthermore, if a peer company like GDF makes huge losses from the swap and forward then the entire industry will be subjected to intense and strict regulations. It will not be fair for companies that have always adopted a policy of low-risk exposure. That is why; the leading companies in the market were skeptical of GDF’s liability management program. Work Cited Pinaskovitch, Arthur. "Currency Swap Basics." Investopedia., N.d. Web. 14 Nov. 2014 . Read More