New on FinoLib · Volume III: Finance Encyclopedia
New on FinoLib, my finance education website: I have published an article called Sovereign Debt Crisis Case Study: Fully Traced, from Volume III: Finance Encyclopedia. Here is what the article explains, written as a short expert briefing; the full piece, with every worked example, is one click away.
The idea in plain words
This case traces a sovereign debt crisis. A government that borrows in foreign currency sees its debt ratio jump when its own currency falls: a 30% fall lifts dollar debt worth 30% of GDP to 42.86% overnight. The shock then spreads through auctions, ratings, forced selling and wider spreads. A company that owes dollars on a known date can use a forward priced by interest-rate parity to turn an open-ended loss into a known cost.
Key points
■Foreign-currency debt cannot be repaid by creating money, which is why currency mismatches sit at the center of most emerging-market crises.
■The forward rate reflects the interest differential: 50 × 1.12 ÷ 1.05 = 53.33, a price, not a forecast.
■Hedging costs 8.9% of equity if nothing happens; not hedging costs 57.1% of equity if the currency falls 30%.
■Hedge the exposure, never more; matching dollar revenue on the same dates is a natural hedge.
A closer look
The situation: Country X (illustrative), an emerging-market economy, has government debt of 60% of GDP, half of it in US dollars. Its currency trades at 50 local currency units (LCU) per dollar. Investor confidence breaks and the currency loses 30% of its value. The decision belongs to the treasurer of a Country X manufacturer that imports components, earns in LCU, and owes $40 million due in one year. The question, asked before the crisis: hedge or not?
Pricing the hedge. The one-year forward exchange rate is set by interest rate parity: F = S × (1 + i_LCU) ÷ (1 + i_USD) = 50 × 1.12 ÷ 1.05 = 53.33 LCU per dollar, with LCU deposits paying 12% and dollar deposits 5%. The forward is 6.67% above spot because of the interest differential, not because anyone forecasts a 6.67% fall; a forward is a price, not a prediction (Volume II §4.1). A bank that sold the forward at any other price could be arbitraged by borrowing in one currency and depositing in the other.
A worked example
Worked Example — Compare the Scenarios: The Treasurer’s $40 Million
Cost in LCU of paying $40 million in one year, unhedged or hedged with a forward at 53.33. The company’s equity is LCU 1,500 million. Scenario in one year LCU per dollar Cost unhedged Cost hedged Hedge gain or (cost) LCU stable 50.00 LCU 2,000.0m LCU 2,133.3m (LCU 133.3m) LCU falls 6.25% 53.33 LCU 2,133.3m LCU 2,133.3m LCU 0 LCU falls 30% 71.43 LCU 2,857.1m LCU 2,133.3m LCU 723.8m The flip point is a fall in the LCU of 1 − 50 ÷ 53.33 = 6.25% (the dollar rising 6.67%).
Under the hood
Under the Hood: Why the Forward Must Be 53.33
Suppose a bank quoted the one-year forward at 52.00 instead of 53.33. A trader borrows $1 million at 5%, owing $1.05 million in a year; converts it at spot into LCU 50 million and deposits it at 12%, which grows to LCU 56 million; and today buys dollars forward at 52.00, so the LCU 56 million becomes 56 ÷ 52 = $1,076,923 at maturity. After repaying $1.05 million, $26,923 remains, with no exchange-rate risk taken.
Decision rule
If you owe foreign currency on a known date and earn in local currency, hedge the known amount for that date when the hedge’s cost if nothing happens (the interest differential, here 8.9% of equity) is smaller than the loss you could not absorb in a severe depreciation (here 57.1% of equity at −30%). Size the hedge to the exposure, never above it; the excess is a speculative position.
The costliest mistake
Leaving a known dollar payment unhedged because the forward “looks expensive.” The forward’s premium over spot reflects the interest differential, so it looks like a cost every year until the year it is not. In this case, saving LCU 133.3 million (8.9% of equity) in a calm year meant risking LCU 857.1 million (57.1% of equity) in a crash — and the crash comes at the moment refinancing is hardest, because the same confidence shock that sinks the currency closes local credit markets.
Recap
A currency fall raises the burden of foreign-currency debt at once — from 60% to 72.86% of GDP in Country X with no new borrowing — and the stress spreads through weak auctions, downgrades across the investment-grade line, foreign selling and wider spreads.
What the full article covers
The full article includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Sovereign Debt Crisis Case Study: Fully Traced, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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