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In this paper (box 1 page 24): https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Bulletins/2000/2000mar63-1brookeshargreaveslucaswhite.pdf

It is argued that the forward rate that a corporation receives from entering a forward contract (let's call it $F$) is the same as the implied forward rate from issuing foreign debt (let's call it $\hat{F}$).

Under the assumption that CIP holds, I disagree.

In particular, assume a european corporation that wants to hedge a future exposure (for example coming from future dollar receipts) by buying euros forwards. Then the direct way to do this would be to enter a forward contract and receive euros at the forward rate, $F$; where according to CIP, $F$ is given by:

$F = S \frac{(1+i_{euro})}{(1+i_{dollar})}$

where $S$ is the spot exchange rate (in terms of euros per dollar) and $i_{euro}$ is the interest rate in euro and $i_{dollar}$ is the interest rate in dollar). Because the corporation is presumably entering a transaction with a bank and it is posting a margin collateral, the interest rates could be assumed to be equal to the LIBOR rates.

The paper argues that $F$ can be derived synthetically: the corporation could issue a zero coupon dollar bond, swap the notional in euro at spot $S$ and invest it at the euro rate. The implied forward rate $\hat{F}$ would then be equal to $F$.

My objection is that in this latter case the interest rate at which the corporation is borrowing in dollars must be different from the USD LIBOR rate; in particular I expect that it would reflect a spread due to a risk premium specific to the corporation issuing the dollar bond.

My conclusion is therefore that $\hat{F} < F $ and hence that it would be cheaper for the corporation to hedge the FX exposure by entering into a forward contract.

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  • $\begingroup$ Not sure if this is still active, but I think if we're speaking down to the minutiae of including the risk on issuing the debt for achieving F, the \hat{F} would include some credit adjustment for the credit risk of the corporation and make that value slightly higher than some theoretically risk free counterparty. $\endgroup$
    – Tanay Trivedi
    Dec 17, 2019 at 4:33

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I don't really agree. The corporation could issue dollar debt, convert the proceeds into Euros and then use this to reduce their amount of Euro debt (either buy some bonds back or issue less). Thus, what is important is the relative spread over Libor that the corporation debt trades at , in dollars versus Euros.

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  • $\begingroup$ Thank You. Are you referring to this strategy in the context of FX hedging? In the sense, that the firm by buying back her own debt can in fact save an amount of interest which will then go in the determination of an implied forward rate: $\hat{F} = S \frac{1+i_e^c}{1+i_d^c}$, where $i_e^c$ is the corporate bond rate in euros and $i_e^c$ is the corporate bond rate in dollars? $\endgroup$
    – night_owl89
    Aug 24, 2018 at 13:24
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Thanks for pointing it out, it appears that you are right, one of the benefits of using futures or forwards is the interest rates used to calculate their value are indeed lower than a corporation could achieve on their own by borrowing in the capital markets due to the risk premium, as you mentioned. So unless a corporation can borrow at the risk free rate, they should hedge with forwards, which I believe is what the author concludes as well, since this is a simpler transaction.

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  • $\begingroup$ Thank You! One comment: do you think that the recent deviations in CIP that we have been observing would to some extent reverse this conclusion? For instance, as it became more expensive to borrow through financial intermediaries would you expect to see a shift toward using foreign currency bonds for hedging purposes? $\endgroup$
    – night_owl89
    Jul 20, 2018 at 15:48

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