Italy Case Study

Part 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 JPY

c). 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 rates

Graph f(2): Face value as a function of exchange rates

Due 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:

Maturities 0.500 1.000 1.500 2.000 2.500 3.000

Italy 0.100 0.105 0.110 0.112 0.113 0.120

Japan 0.011 0.013 0.013 0.015 0.020 0.022

ert(ITL) 1.051 1.111 1.179 1.251 1.326 1.433

ert(JPY) 1.006 1.013 1.020 1.030 1.051 1.068

Forward exchange rate 20.910 21.927 23.132 24.282 25.235 26.836

h). 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.

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 Term ITL Term

Face value of 1 Bond 100.0000 1,330.0000

Coupon payment 1.0974 14.5953

Principal at maturity 100.0000 1,330.0000

Fair price 101.3197 1,347.5517

Total value 50,659,837.6144 673,775,840.2712

b). (Spreadsheet see Appendix 2-b)

Summary Table 2(b)

JPY Term ITL Term

Face value of 1 Bond 7.5188 100.0000

Coupon payment 0.4592 6.1071

Principal at maturity 7.5188 100.0000

Fair price 7.6147 101.2753

Total value 76,146,812.7098 1,012,752,609.0405

c). 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 swaps

a). 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