Hedging a Foreign Currency Bond or Loan

Let us now consider the case of a bond issued in a foreign currency Y different from our domestic currency X. This actually applies not just to foreign and domestic currencies in a strict sense, but we could define more loosely Y as a currency the institution does not want to have exposure to and X as a currency the institution does want to have an exposure to. An institution will always have one and only one reporting currency (the currency in which its financial statement is published) and therefore all exposure to all currencies will always be measured against its reporting currency. However, this does not mean that the institution will not have exposure to currencies other than its reporting currency.

Let us illustrate how the conversion works and then we shall offer some examples of the types of currencies that might be involved in the conversion.

In Table 7.3 we show the situation where we have issued a bond in currency Y with a coupon Fi which can be anything from a fixed coupon, a simple floating-rate coupon, or a structured coupon. The bond's true nature is not relevant here; what matters is only the fact that the currency of the bond is not one to which we care to have exposure. All the symbols have the usual meanings, in particular is the discount factor in currency Y and is the correction to the market discount factor due to the cost of borrowing in currency Y.

After issuing the foreign currency bond we would enter into a cross currency swap where we would receive a stream of cash flows equal to those of the bond and pay a set of cash flows in currency X, constituted by the X currency floating rate plus a spread. The spread, as usual, is such that the two transactions (bond and swap) are financially equivalent.

The outcome of this strategy, as shown in the last line of Table 7.3, is that we pay a stream of floating cash flows in currency X. Note that, similar to the situation shown in Section 7.3.1.1, when calculating the present value of the bond and the Y currency leg of the swap, the two do not perfectly offset. This is due to the fact that we discount the two sets of cash flows with two different curves: with a discount curve driven by LIBOR or OIS rates in the case of the swap and by our own cost of funding in currency Y[1] in the case of the bond. We have defined this difference with the quantity ΦY, which is given by

(7.10)

At the beginning of the section we explained how for every institution there is only one reporting currency, but there could be multiple currencies to which the institution wishes to gain exposure. An institution, particularly a development institution as seen in Section 4.3.1, would issue in a great variety of currencies: the choices behind issuing in these currencies go from specific development reasons to a search for an attractive funding level. After the issuance we have seen the institution enter into a cross currency asset swap (a static hedge).

Let us imagine that the reporting currency of the institution is USD: this means that many cross currency asset swaps would be into USD. However the institution might choose to have additional active exposure to, say, EUR, JPY, and GBR This means that not only some debt will be issued directly in EUR, JPY, and GBP but also that debt issued in, say, Indonesian Rupees (IDR) could be swapped into either USD, the main reporting currency, or EUR, JPY, and GBP.

Let us mention here the special case of nondeliverable currencies. We mentioned in Section 4.2.4 that some (developing) countries exercise capital control on their currencies, meaning that their currencies cannot be freely transferred outside of the country. This control of capital results in the creation of nondeliverable bonds and nondeliverable swaps, instruments where, every time there is a cash flow in the controlled currency Z, in order for a foreigner to take possession of it, it needs to be converted into (usually) USD. These types of bonds are issued only to foreigners and the currency in which the cash flow will be delivered is stated in the bond's terms.

An investor purchasing this type of instrument applies a strategy similar to the one mentioned in Section 6.4.2, where the divergence between FX forward and FX spot is exploited. The coupon in the bond will be high because there is an expected (and therefore reflected in the FX forwards) depreciation in the nondeliverable currency; however, this depreciation might not actually materialize at the moment of exchanging the cash flow in USD.

The net result is that the investor is purchasing a USD floating-rate note with a coupon that could be higher than if the note had been in USD to start with.

If parties A and B enter into a nondeliverable swap contract where A pays USD cash flows to B and B pays Z-denominated cash flows to A, in practice both parties will receive USD. One can generalize and say that the near totality of capital-controlled trades involve fixed cash flows and therefore in order to hedge a bond issued in a nondeliverable currency one should not consider the situation shown in Table 7.3, but rather the one shown in Table 7.4.

In order to vary our examples and also because it is easier to appreciate the difference between deliverable and nondeliverable currencies, we have

TABLE 7.4 The hedging of a bond in a nondeliverable currency Z purchased as an investment.

Instrument type

Pay/Receive

Leg structure

Bond (denominated in Z

Receive

but deliverable in USD)

Floating Swap Leg (in USD)

Pay

Floating Swap Leg (in USD)

Receive

Result

Receive

TABLE 7.5 The hedging of a fixed- or floating-rate loan in a foreign currency.

Instrument type

Pay/Receive

Leg structure

Loan in currency Y

Receive

Swap Leg in currency Y

Pay

Swap Leg in currency X

Receive

Result

Receive

considered the situation where instead of selling, that is, issuing, a bond, we purchase one. This could be the situation encountered by the investment arm of the institution.

After purchasing the (fixed-rate) bond denominated in the nondeliver- able currency Z, we know immediately that at every coupon date we shall receive an amount CNZF X of USD, where C is the coupon, Nz is the principal amount in currency Z, and F Xi is the spot FX rate at time 7] between Z and USD. We are therefore in the position in which we receive a set of varying coupons in USD. We can then enter into a purely USD swap in which we pay the set of cash flows we receive from the bond and receive a set of floating rates linked to a USD floating rate plus spread. As usual, the spread is such that the previous transactions are financially equivalent. Although we have said that the swap is purely USD, this is true only in practice. The actual definition of the swap is as nondeliverable, that is, one where we pay flows in currency Z: the fact that Z is a nondeliverable currency results in us making USD payments in practice.

The outcome is a stream of floating USD-denominated cash flows. In this case the amount Ф$ refers to the discounting discrepancy between the effectively USD value of the bond and the corresponding leg in the swap.

For completeness we shall mention the situation in which we want to hedge the exposure to a currency Y in which we have extended a loan. As shown in Table 7.5 we are receiving a set of coupons F, (which can be either fix or floating) on a principal NY and repayments of the same principal. We would enter into an amortizing cross currency swap in which we pay the same coupons and receive a set payment made of a coupon indexed to a floating rate plus spread on a principal Nx and repayments of the same principal. The outcome is an exposure to a floating rate in X.

Typically an institution would set itself currency diversification targets: set percentages of the assets, debt, and equity need to be denominated in those currencies to which the institution wishes to have exposures. If, after operations such as the ones shown in these sections, the actual net (hopefully

TABLE 7.6 The hedging of an investment in an ABS with an asset swap.

Instrument type

Pay/Receive

Leg structure

Fixed/Floating ABS

Receive

Fixed/Floating Swap Leg

Pay

Floating Swap Leg

Receive

Result

Receive

positive) income does not fall within these percentages, this will be corrected with spot FX transactions.

  • [1] See Section 6.4.1, where we discussed funding in different currencies.
 
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