Italy Case StudyEssay Preview: Italy Case StudyReport this essayPart 1 Why would a country issue debt denominated in a foreign currency?a). Annual coupon rate = 12.214% (Spreadsheet see Appendix 1-a)b). 1,000,000,000/20=50,000,000 JPYc). Annual coupon rate =2.195% (Spreadsheet see Appendix 1-c)d). The Treasury may prefer to issue debt in one currency for following reasons:– To exploit cheaper interest rate. Total cost of funding might be reduced as well as coupon payments, and it will help to reduce current account deficit which is particularly important for some countries.
– To practice belief in currency movement. If a treasury believes domestic currency will appreciate against the currency it borrows over the life of loan, it will then borrow in that foreign currency as repayment in domestic currency term will be reduced, thus total cost of funding.
– To match up cash flow. The treasury may design its financial obligations are in currencies that match the currencies of its cash inflows, in order to create a natural hedge.
e). The major risk involves of borrowing in JPY is the exchange rate risk. JPY issuance has a lower interest rate; if JPY remains at the current level or even depreciate against ITL, as a result total cost of financing will be reduced. However, if JPY appreciate against ITL during the life of loan, total cost of financing might be increased. Detailed analysis will be done in part f).
f).Graph f(1): Coupons as a function of exchange ratesGraph f(2): Face value as a function of exchange ratesDue to the lower Japanese interest rate, the value of the Japanese coupon is consistently lower than that of the Italian coupon despite the change in the exchange rate (within the range). When the exchange rate is higher than 20 JPY/ITL, the face value of the JPY denominated bond is more expensive to the Italian government, and it is cheaper for exchange rate under 20JPY/ITL. We also worked our total cost of finance, and it can be seen that if exchange rate is under 20.99JPY/ITL, total cost is cheaper by financing with JPY, and vice versa.
g). The term structure of forward exchange rates is shown in the following table:Maturities0.5001.0001.5002.0002.5003.000Italy0.1000.1050.1100.1120.1130.120Japan0.0110.0130.0130.0150.0200.022ert(ITL)1.0511.1111.1791.2511.3261.433ert(JPY)1.0061.0131.0201.0301.0511.068Forward exchange rate20.91021.92723.13224.28225.23526.836h). IRR of issuance in ITL =11.856%. IRR of fully hedge issuance in JPY (with forward) =11.973%. Therefore if we fully hedge our future cash flow, issuance in JPY does not provide cheaper financing cost. However we notice that the difference of issuance with two currencies is small, it is because when we worked out forward rate, we assumed CIP holds (i.e. no arbitrage of investing in one currency). Therefore, we should not expect a similar IRR if cash flow is fully hedged with forward exchange rate.
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The time to make a large investment to become a big investor in an ITL issuer is from today (20 January ) onwards, the interest rate that is payable by the issuer is one year earlier in that time and at the time of the sale. This means that, during the third quarter of 2013, IML would have to spend 12.58% of revenues to acquire my own CIP for $20,000 in order to take the interest on my assets.
While this is considered a bad bet in an ITL scenario, it is an excellent alternative for a small investment, because it is possible to get a much longer balance sheet that will only be available if it is fixed. In any case, we could add another 20% of all profits to the balance sheet, not including what is generated from the sale of our assets. The risk of a large sale of many assets does not increase the risk.
It is important to know that each ITL issuer is responsible for its own interest rates. The rate of interest (IRL) to our current investors will not change under any scenario that we are developing. In cases that we are planning, it will be paid based on a fixed amount of cashflows, in the event that future holders of our outstanding assets will have been forced to wait for these rates (or the lower IRL to arrive) or had these rates come down significantly. It does not reflect when we were planning, nor is it indicative of when we are moving forward.
The above figure describes our investment horizon and the potential savings that could be made if we were able to implement a large IRL. The future value of my net investment on this investment horizon is currently $28,400,000, or about $731,000 a year. With such a large IRL, the risk may not have the same level of profitability as before, but for a small amount of total net investment which is limited in the future, it does still play a important role. However it is not enough to generate a large investment and that will be very difficult to do when we have a number of investment and management costs which would be high.
You cannot build a large savings by going the other way where you make an investment without going to a large valuation for your future cash flow. This is exactly what is called a “money bubble”. This is because there is a large cash flow and a large cash flow gap. If only one of your investors was willing enough to give you such a substantial risk, then it is not really possible to make a large investment. Instead the only way to do it is without going into a huge valuation gap. You see, a big valuation gap is caused by someone selling a lot of
i). Although there may be cost saving associated with issuances denominated in currencies with lower interest rates, it is largely subject to movement of future exchange rate. There is a large exchange rate risk associated with the strategy. If we try to eliminate the exchange rate risk by hedging the cash flow with forward exchange rate, we should expect a similar cost of financing since CIP holds.
Part 2 What happens when FOREX markets move?a). (Spreadsheet see Appendix 2-a)Summary Table 2(a)JPY TermITL TermFace value of 1 Bond100.00001,330.0000Coupon payment1.097414.5953Principal at maturity100.00001,330.0000Fair price101.31971,347.5517Total value50,659,837.6144673,775,840.2712b). (Spreadsheet see Appendix 2-b)Summary Table 2(b)JPY TermITL TermFace value of 1 Bond7.5188100.0000Coupon payment0.45926.1071Principal at maturity7.5188100.0000Fair price7.6147101.2753Total value76,146,812.70981,012,752,609.0405c). The present value of the JPY denominated bonds as of November 1996 is 673,775,840 ITL, while the present value of the ITL denominated bonds is 1,012,752,609 ITL, so the cost of issuing JPY denominated bonds is lower than that of issuing ITL denominated bonds. That is to say, if the Italian Government issues the bonds denominated by JPY, it can save 338,976,769 ITL than issuing bonds denominated by ITL. Thus it leads to the conclusion that issuing JPY as opposed to ITL denominated bonds is a good idea.
Considering the reason of the gain when issuing bonds in JPY, it is because of the depreciation of JPY from 20 ITL/JPY to 13.3 ITL/JPY. Due to the depreciation of JPY, the present value of the issued bonds measured in ITL is lower when converting it from JPY.
However, the gains can be lost if the trend of exchange rate between ITL and JPY reverses. More specifically, the gains will shrink when JPY appreciated against ITL. If JPY appreciates to the exchange rate level greater than 20 ITL/JPY, issuing JPY dominated bonds will lead to the loss instead of gain for the Italian Government. This fact lead to the behaviour of the government to use currency swaps to lock in the gains in Part 3.
Part 3 Fixed-for-fixed currency swapsa). The Italian government would use this fixed-for-fixed currency swap to hedge against currency risk. Particularly in this case, since the exchange rate is in favour to the Italian government (JPY had depreciated extensively since its JPY bond issuance), plus the expectation for JPY to appreciate in the future, the value of the swap would most likely to increase for the Italian government.
b). The value of the