Chapter 11 Outline

Foreign Exchange Risk and the Cost of Capital

We have emphasized repeatedly that a firm can borrow funds at a lower cost on the global capital market than on the domestic capital market. However, we have also mentioned that under a floating exchange rate regime, foreign exchange risk complicates this picture. Adverse movements in foreign exchange rates can substantially increase the cost of foreign currency loans, which is what happened to many Asian companies during the 1997 - 98 Asian financial crisis.

Consider a South Korean firm that wants to borrow 1 billion Korean won for one year to fund a capital investment project. The company can borrow this money from a Korean bank at an interest rate of 10 percent, and at the end of the year pay back the loan plus interest, for a total of W 1.10 billion. Or the firm could borrow dollars from an international bank at a 6 percent interest rate. At the prevailing exchange rate of $1=W 1,000, the firm would borrow $1 million and the total loan cost would be $1.06 million, or W1.06 billion. By borrowing dollars, the firm could reduce its cost of capital by 4 percent, or W40 million. However, this saving is predicated on the assumption that during the year of the loan, the dollar/won exchange rate stays constant. Instead, imagine that the won depreciates sharply against the US dollar during the year and ends the year at $1=W1,500. (This occurred in late 1997 when the won declined in value from $1=W1,000 to $1=W1,500 in two months.) The firm still has to pay the international bank $1.06 million at the end of the year, but now this costs the company W1.59 billion (i.e., $1.06 * 1,500). As a result of the depreciation in the value of the won, the cost of borrowing in US dollars has soared from 6 percent to 59 percent, a huge rise in the firm's cost of capital. Although this may seem like an extreme example, it happened to many South Korean firms in 1997 at the height of the Asian financial crisis. Not surprisingly, many of them were pushed into technical default on their loans.

Unpredictable movements in exchange rates can inject risk into foreign currency borrowing, making something that initially seems less expensive ultimately much more expensive. The borrower can hedge against such a possibility by entering into a forward contract to purchase the required amount of the currency being borrowed at a predetermined exchange rate when the loan comes due (see Chapter 9 for details). Although this will raise the borrower's cost of capital, the added insurance limits the risk involved in such a transaction. Unfortunately, many Asian borrowers did not hedge their dollar-denominated short-term debt, so when their currencies collapsed against the dollar in 1997, many saw a sharp increase in their cost of capital.

When a firm borrows funds from the global capital market, it must weigh the benefits of a lower interest rate against the risks of an increase in the real cost of capital due to adverse exchange rate movements. Although using forward exchange markets may lower foreign exchange risk with short-term borrowings, it cannot remove the risk. Most importantly, the forward exchange market does not provide adequate coverage for long-term borrowings.