The Impact of Inflation and Devaluation on the Selection of an International Borrowing Source: A Note
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ofAlberta University * Intheirrecent articlein this Journal,de Faroand Juckeraddressed the problemof INTRODUCTION choosing internationalborrowingsources. Theirapproach consisted of identifyingthe effective interestrates inthe variousmarketsand comparinginterestcosts withexpected devaluation-picking the source withleast expected costs withoutconsiderationof the riskinvolved.1 Lower expected cost is likelyto be a majorreason for borrowingforeign currencies althoughnotthe only one. Otherreasons may be thindomestic capital marketsrelative to financing requirements,comparativeabsence of disclosure rules and shorterlead time, hedging of balance sheet exposure by multinationals,as well as controls on capital flows-such as the U.S. programending in January 1974. Yet, in the last few years, exchange rates have been more volatile,interestrates have been higher than in the past, and the average termto maturityinthe Eurobondmarket has been a historicallylow 5-7 years. All of these developments implya higher exchange riskforborrowersof foreigncurrencies.Inotherwords, thoughsuch borrowing may have lower expected costs, these may be obtained at the riskof a considerable range of actual borrowingcosts as time passes. The purpose of this short note is to bring into sharper focus this riskof actuallyhigher than expected costs of borrowingforeign currencies. Some financialexecutives may not be at all concerned withthe stabilityof borrowingcosts; others, however,may not have a stomach forthis added risk.Applicationof portfolioselection theoryintroduced and recentlyextended to thiscontext by de Faroand Juckerthemselves3 by Markowitz2 can help illustratethe problem of selecting an internationalborrowingsource under uncertaintyby makingvarious assumptions about the degree of riskaversion.
To concentrateon the main idea, we willsimplifythe problemto two sources of funds.4 And to lend realism to the discussion, we consider a Canadian borrowerbecause Canada has traditionallyhad higher interestrates than the U.S., and Canadianfirms have been heavy borrowersin foreign markets.Our hypotheticalCanadianfirmcan borrowat effective interestrateRCAN.Thiscost is certain.Abroad-e.g., inthe U.S. or in Europe-it can borrowat the nominalrate RUS, RUS
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