International Finance: Contemporary Issues

By Dilip K. Das | Go to book overview

22

THE DEBT DENOMINATION DECISION

Robert Z. Aliber

The key decision in international financial management is the debt denomination decision. When borrowing, managers of firms must decide whether to sell new debt and bank loans denominated in their domestic currency or in a foreign currency. Domestic currency, for all practical purposes, is the currency in which the firm reports its income to its stockholders, or to its owners. For most purposes the relevant foreign currency is either the currency of one of the foreign countries in which the firm sells or produces, or the currency of one of the small number of countries in which the firm can borrow readily. The choice of currency for the denomination of debt and bank loans affects both the level and the variability of the firm's income because it impacts on net interest payments and foreign exchange gains and losses.

The key elements in the debt denomination decision can be grouped into two sets. First, the market factor set includes the interest rates on bonds and bank loans denominated in the domestic currency, the interest rates on comparable bonds and bank loans denominated in one of several foreign currencies and the anticipated change in the exchange rate for each of these foreign currencies in terms of domestic currency. Second, the firm-specific factor set includes the foreign exchange exposure associated with the various components of the firm's income statement and its balance sheet, the risk associated with individual foreign currencies, the risk of a portfolio of various foreign currencies and the relation between the firm's total income and capital gain (or loss) from a change in the exchange rate at a time when the firm has a foreign exchange exposure.

The central decision for the firm is whether the currency denomination of its debt and its bank loans should be managed to reduce or fully neutralize the foreign exchange exposure of its income statement or whether the currency denomination of its debt and bank loans should be managed to increase its net income, either by reducing its borrowing costs or by increasing its foreign exchange gains-at least in an anticipated sense. The inputs to this decision include both the market factors (the relation between the interest rates on comparable bonds denominated in different currencies and the anticipated change in exchange rates) and the firm-specific factors (the firm's attitude toward risk and the relation between the income associated with changes in the firm's foreign exchange exposure and its total income). An individual firm might, and should, have different postures toward maintaining foreign exchange exposures in different groups of currencies, because the market factors associated with each of these groups of currencies might differ. Two firms involved with the same group of foreign currencies may follow quite different policies when making the debt denomination decision because of differences in their attitudes toward risk.

The debt denomination decision for the firm is the mirror image of the portfolio decision of the investor. The key elements in the portfolio decision are all present in the debt denomination decision-the interest rates on comparable assets denominated in various foreign currencies and in the

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