International Financial Management - Floating Rate Bonds - Assignment Example

International Financial Management - Floating Rate Bonds 1. Floating Rate Bonds a. What factors should be considered by a U.S. firm that plans to issue a floated rate bond denominated in a foreign currency? Answer: A number of factors need to be considered by U.S. Firms while issuing floated rate bonds. First and foremost, the most essential aspect that needs to be considered is the interest rate of the currencies. It is also essential for the firms to learn more about the exchange rates by studying the trends as well as the forecast as relative to that of the home currency. It is also essential for the firm to concentrate and learn if there will be future cash inflows in the foreign currencies (Madura, 2010). It is essential to learn whether or not the currency could denominate the bond. Another important element that also needs to be noted is the possible future of the coupon rate. This also plays a very important role in the decision making process. b. Is the risk of issuing a floating rate bond higher or lower than the risk of issuing a fixed rate bond? Explain. Answer: Although a number of companies might feel that the risk of a fixed rate bond is relatively lower than that of a floating rate bond, the answer cannot be definitive. It is essential to note that in the case of floating rate bonds there is a chance for the interest rates to rise and increase (Professional Risk Managers' International Association (PRMIA), 2007). However in the case of a fixed rate bond, the companies are at a risk as they would still be liable to pay the coupon rate, irrespective of the interest rates, i.e. even if it declines. The only reason why a fixed rate bond can sometimes be considered to be less risky is the fact that the companies have a set figure that they need to pay in terms of the coupon rate. c. How would an investing firm differ from a borrowing firm in the features (i.e., interest rate and currency’s future exchange rates) it would prefer a floating rate foreign currency-denominated bond to exhibit? Answer: Investing firms differ from borrowing firms to a great extent. Firstly, an investing firm will tend to prefer bonds in currency which has a higher interest rate and which shows promise to rise as well in the future. These firms tend to rely on the trends of the currency prices and prefer choosing currencies which are growing (Bekaert & Hodrick, 2008). On the other hand, a borrowing firm concentrates on currency which have low interest rates and which are expected to reduce. This is simply because it allows the company to pay much lower rates of interest and permits a higher chance for increased benefits (Resnick, 2008). Hence the two firms tend to expect two different features in the future currency exchange rate. 2. Risk from Issuing Foreign Currency-Denominated Bonds. a) What is the advantage of using simulation to assess the bond financing position? Answer: Simulations tend to be very beneficial for the bond financing positions. Here the stimulations tend to provide a clear distribution of all the possible outcomes unlike in the case of point forecasts. With the help of the stimulations firms can gain a better idea of the probability of the cost of the source of funds and can also be sure of that the foreign issue bonds will prove to be less expensive (Professional Risk Managers' International Association (PRMIA), 2007). On the whole the main benefits is that it provides the firms with a clear view and taste of all possible outcomes which in turn allows a more educated approach and well planned decision making process. This helps in reducing or eliminating the risks to a great extent. 3. Exchange Rate Effects. a. Explain the difference in the cost of financing with foreign currencies during a strong-dollar period versus a weak-dollar period for a U.S. firm. Answer: The cost of financing and the foreign currencies tend to be inversely proportional to each other. When a foreign currency is low, the cost of financing for the firms is relatively high when the dollar strengthens (Resnick, 2008). However it is a completely opposite case when the dollar weakens. In a situation where the dollar weakens, the cost of financing for the companies tends to become much higher. b. Explain how a U.S. based MNC issuing bonds denominated in Euros may be able to offset a portion of its exchange rate risk. Answer: There are a few different methods that can be used for the US based MNCs to offset the exchange rate risks. One of them is to ensure that the inflows of the company are in Euros, which allows the company to use the same Euros for coupon payments as well (Bekaert & Hodrick, 2008). Another excellent option for the company is to enter the specific interest rate swaps. It is essential that the SWAPS are with Euro based MNCs with the denominations in dollar for the bonds. This would mean that the on the date of the interest, the Euro MNC will be paid by the US MNC for covering the interest in the SWAPs and the company will receive the Euros as states in the SWAP (Professional Risk Managers' International Association (PRMIA), 2007). These methods prove to be most effective for the offsetting of the exchange rate risks. 4. Bond offering decision a) Columbia Corp. is a U.S. Company with no foreign currency cash flows. It plans to issue either a bond denominated in Euros with a fixed interest rate or a bond denominated in U.S. Dollar with a floating interest rate. It estimates its periodic dollar cash flows for each bond. Which bond do you think would have greater uncertainty surrounding these future dollar cash flows? Explain. Answer: It is a known fact that over time, exchange rates tend to be very volatile when compared to the interest rates. Hence when dealing with a foreign exchange transaction, like a Euro denominated bonds, it will be relatively much more uncertain than the dollar payments for the floating rate bonds (Madura, 2010). This is mainly because the former involves an international transaction and deals with a foreign exchange currency, while the latter deals with the local currency, thereby reducing the uncertainty to quite an extent. It is also essential to note that the payments of the principles are based on the exchange rate risks and lesser on the interest rate risks. 5. Currency Diversification a) Why would a U.S. firm consider issuing bonds denominated in multiple currencies? Answer: As the foreign exchange rates are quite volatile, a US firm can use this to their advantage by investing in multiple currencies. By doing so, the firm will be able to reduce the risks that are involved in the exchange rate (Madura, 2010). Also, it is essential to note that this is an option adopted by the company when there is relatively much lesser correlated to each other. This helps the firm spread the risk out well and permits a better chance for reduced exchange rate risks. Hence it is clear that the underlying reason for firms to consider issuing bonds denominated in multiple currencies is mainly to reduce the risk of exchange rates and to try to balance out based on the exchange rates (Resnick, 2008). References Bekaert, G., & Hodrick, R. J. (2008). International Financial Management. Prentice Hall. Madura, J. (2010). International Financial Management. 10 edition: South-Western. Professional Risk Managers' International Association (PRMIA). (2007). The Professional Risk Managers' Guide to Financial Instruments. McGraw-Hill. Resnick, B. (2008). International Financial Management. 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