1 Know the following the 3 main sources of firm financing how the effective interest rate on a bank line of credit is calculated interest cost commitment fee compensating balance requirement plus loan covenants that have to be satisfied the main short term investment alternatives for a firm e g sweep accounts commercial paper treasury securities and how the discount yield is computed applies to treasury securities commercial paper corporate bonds etc The 3 main sources of firm financing are 1 Commercial paper accounting for 126B 2 9 2 Bank loans accounting for 746B 16 9 and 3 Corporate bonds accounting for 2 698B 61 2 totaling 3 570B and 81 A bank line of credit is the main short term investment for a firm The effective interest rate on a bank line of credit takes the following into account 1 Banks require firms to hold a DDA compensating balance e g 20 of any borrowed amount may be held idle This being the main point 2 Banks charge a loan commitment fee on the value of the unused line e g 25BP on unused loan amount minor element 3 Banks charge interest on the value of the loan made the value the firm can use the idle compensating balance 4 Banks impose loan covenants that need to be met before the line of credit can be used e g if leverage x then no funds 5 Banks require that the entire borrowed amount be returned for a few weeks each year to make sure that S T loan is really used for S T purposes not L T use which would carry a higher rate Example Bank line of credit 100 000 Interest rate on used line 10 Commitment fee on unused portion 25BP 0025 Compensating balance 20 of the loan so only 80 of the value of the line can ever be actually used by the firm Stated interest rate 10 Effective Interest Rate value of usable funds out of total borrowed x Out of pocket expenses 365 daysborrowed A firm borrows 60 000 of its 100 000 bank line of credit Out of pocket costs Usable balance Interest expense 10 60 000 6 000 yr unused line Commitment fee 0025 100 000 60 000 0025 40 000 100 yr Compensating balance 20 60 000 12 000 held idle at bank E f fective Interest Rate 6k 100 60 k 12k x 365 365 1271 12 71 12 71 10 stated interest rat e The main short term investment alternatives for firms include sweep accounts discount yield instruments and repurchase agreements Sweep accounts Firm s excess collected DDA funds swept into interest earning investments overnight pay bank fees for this service Discount yield instruments Face value market price Treasury bills Commercial paper Banker s acceptances Repurchase agreements Firm buys government securities from a bank to earn interest This gives the bank an overnight loan Bank buys back the securities the next day Around 10 of firm S T investments are REPOs Face value 2 Know how spot and forward exchange rates work Be able to determine if an exchange rate has appreciated or depreciated and what this means for a country s price of imports seen at home and price of exports seen overseas Spot exchange rates are today s exchange rates UK pound European euro Japanese yen Example Jan 2010 per 1 6020 1 00 cost of 1 per 1 1 661 1 00 cost of 1 One spot rate is the inverse of the other 1 6020 1 661 1 1 661 6020 Forward exchange rates are exchange rates in the future 1 week to 10 years Expected appreciation Spot St 1 661 Forward 6 mo Ft 180 1 59 1 cost of 1 falls by 1 661 1 59 4 3 1 661 appreciates so pay fewer to get 1 sells at a discount Expected depreciation Spot St 1 661 Ft 180 1 70 1 cost of 1 rises by 1 70 1 661 2 3 1 661 depreciates so pay more to get 1 sells at a premium PFX Rise in Demand for Exports Appreciation depreciation 1 70 1 661 1 59 appreciation depreciation 1 70 1 661 1 59 appreciation SFX DX new DX DFX DM X M Value FX SFX DX new DM DFX DM PFX Rise in Demand for Imports Depreciation SFX due to DX when sell more Boeing jets or when US receives more investment from the UK exports rise and appreciates X M Value FX SFX due to DX when sell fewer Boeing jets or when US receives less investment from the UK exports fall and depreciates DFX due to DM when buy more Italian shoes or when US invests more in the UK DFX due to DM when buy fewer Italian shoes or when US invests less in the UK Example Illustration of exchange rates A US firm has sold 200 million in exports to another firm in Switzerland The current spot rate is 4 00 SF 1 1 Swiss Franc so the Swiss firm has contractually agreed to pay the US firm SF 50 million in 90 days Thus the US firm has an A R of SF 50 million The US firm does not hedge this A R and thus faces FX risk A What is the dollar value received by the US firm if the exchange rate is 4 00 SF 1 Answer 4 00 x SF 50 M 200 M for US firm B What will be the dollar value received by the US firm if the dollar depreciates by 1 in 90 days when the Swiss firm pays up Answer 1 dollar depreciation changes exchange rate from 4 00 SF 1 to 4 04 SF 1 so 4 04 x SF 50 M 202 M received by US firm C What will be the dollar value received by the US firm if the Swiss Franc depreciates by 5 in 90 days Answer 5 depreciation of SF changes exchange rate from 4 00 SF 1 to 4 00 SF 1 05 so 4 00 SF 1 05 x SF 50 M 3 81 x SF 50 M 190 M A 5 SF depreciation 5 appreciation so new exchange rate is 3 81 SF 1 D What is the value of Swiss Francs paid by the Swiss firm if the appreciates by 2 Answer still SF 50 M which was contracted SF amount US has FX risk not Swiss 3 Be able to use a supply and demand graph to show how a flexible exchange rate is determined and how these supply demand curves are related to the demand for imports and the demand for exports Know the two main components of a country s balance of payments current account and capital account and why a net capital inflow into a country e g a foreign investment in a domestic firm is like an export of a product See graphs above for first part of answer supply and demand graphs Fixed versus floating only major currencies float while other currencies are managed in some way to limit the effects of supply demand on their exchange …