CARREFOUR S.A.
Synopsis and Objectives In August 2002, the French retail giant Carrefour S.A. is considering alternative currencies for raising (euros) EUR750 million in the eurobond market. Carrefour’s investment bankers provide various borrowing rates across four different currencies. Despite the high nominal coupon rate and the lack of any material business activity in the United Kingdom, the British-pound issue appears to provide the lowest cost of funds if the exchange rate risk is hedged. The case is designed to serve as an introduction to topics in international finance. Topics of discussion include foreign-currency borrowing, interest-rate parity, currency risk exposure, derivative contracts (in particular forward and swap contracts), and currency risk management. Students are tasked with exploring (1) motives for borrowing in foreign currencies, (2) the exposure created by such financing policy, and (3) strategies for managing currency risk. Suggested Questions for Advance Assignment to Students 1. Why should Carrefour consider borrowing in a currency other than euros? 2. Assuming the bonds are issued at par, what is the cost in euros of each of the bond alternatives? 3. Which debt issue would you recommend and why? Hypothetical Teaching Plan 1. What is going on at Carrefour? 2. Is the Swiss-franc issue, at 3⅝%, a “no-brainer”? 3. What can a firm do to manage the exchange-rate risk of foreign-currency borrowing?
This teaching note was prepared by Professor Michael J. Schill. The managerial issues and lessons in the case draw heavily from an antecedent case, “Emerson Electric Company” (UVA-F-0771), by Robert F. Bruner. Copyright 2005 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 1/09.
-24. Using appropriate forward rates, what is the cost of borrowing in Swiss francs? British pounds? U.S. dollars? What should Carrefour do? As reference material, broad empirical evidence of the managerial question in the case can be found in Matthew R. McBrady and Michael J. Schill, “Foreign currency denominated borrowing in the absence of operating incentives” Journal of Financial Economics 86 (October 2007): 145–177 and Matthew R. McBrady, Sandra Mortal, and Michael J. Schill, “Do firms believe in interest-rate parity?” working paper, Darden Graduate School of Business Administration, University of Virginia, Charlottesville. Case Analysis 1. What is going on at Carrefour? Carrefour is a massive retailer (Europe’s largest) with strong but selective expansion prospects internationally (case Exhibit 1). The company has a history of funding its capital needs through securities denominated in many different currencies (case Exhibit 3), and is sophisticated in managing currency risk. Carrefour currently has a EUR750 million capital need that the company intends to meet through the eurobond market.1 This offering represents approximately 11% of Carrefour’s bond portfolio. Carrefour’s investment bank has provided market borrowing rates in euros and three foreign currencies. Using the prevailing exchange rates, the borrowing alternatives for Carrefour can be specified as 1. Borrow EUR750 million at 5.25% 2. Borrow (British pounds) GBP471 million at 5.375% 3. Borrow (Swiss francs) CHF1,189.75 million at 3.625% 4. Borrow (U.S. dollars) USD735 million at 5.5% If Carrefour borrows in a currency other than the euro, the company can generate its EUR750 million capital need by converting the foreign currency proceeds to euro at the prevailing spot rates of GBP0.628/EUR, CHF1.453/EUR, and USD0.980/EUR.
1 Bob Bruner suggests using the case to develop various facets of the eurobond market: (1) the eurobond market is an external market, outside the regulatory jurisdiction of any one country; (2) the bonds so issued are in unregistered form (i.e., the owner’s name is not cited on the face of the bond itself); (3) coupon payments are made annually, rather than semiannually, as is the custom in the United States; (4) the bonds are issued on an unsecured basis, which effectively limits the demand in this market to only the highest-quality issuers; and (5) the international bond market is huge. In the 1980s, the eurobond market ballooned in trading, new issues, and outstandings, concurrently with the globalization of financial sourcing by governments and corporations.
-32. Is the Swiss-franc issue, at 3⅝%, a “no-brainer”? The Swiss-franc bonds work well as a foil for interest-rate parity. The instructor can ask why Carrefour would ever want to borrow at any rate higher than 3.625%. To go into the specific detail of the alternatives, the instructor can solicit the series of euro payments from the euro bond and the Swiss-franc payments from the Swiss-franc bond (see Exhibit TN1). If one assumes that the future Swiss-franc payments can be converted into euros at the current spot rate of CHF1.453/EUR, the Swiss-franc bond is a “no-brainer.” Astute students will respond to this argument with concerns about the exchange-rate risk exposure. Carrefour will be happy with the decision if the exchange rate stays above the current exchange rate (Swiss-franc depreciation). If, however, the exchange rate declines (Swiss-franc appreciation), Carrefour will have to pay back the debt by buying more expensive francs. If the currency appreciates enough, the borrowing gains will be offset by the exchange-rate losses. The instructor can capture the exchange-rate risk of the Swiss-franc borrowing with the payoff diagram in Exhibit TN2. If students are new to exchange rates, it is worth spending some time on interpreting the trends in Exhibit 6 to understand what is meant by appreciation and depreciation of exchange rates. In the end, students should be comfortable with understanding which direction in exchange rates represents borrowing cost reduction and which direction represents borrowing cost increases. Because exchange rates tend to be volatile, the perceived wisdom is that the exchange-rate risk commonly offsets any potential borrowing gains from nominal interest rate differentials. A common phrase that captures the hazards of accepting foreign-currency risk to achieve interest rate differentials is “picking up nickels in front of bulldozers.” Despite the exchange rate risk, there are plenty of case examples of firms and traders that borrow in currencies with low interest rates and invest in currencies with high interest rates. This strategy is known as the “carry trade.” 3. What can a firm do to manage the exchange-rate risk of foreign-currency borrowing? This challenge motivates the appeal of the forward contract. With exposure to the future exchange rate, students can see the risk management gains from buying a forward contract that locks in a particular exchange rate. Exhibit TN3 shows graphically how the forward contract offsets the currency risk exposure of the foreign-currency debt obligation. To motivate interest-rate parity, the instructor can invite a class member (the banker) to play the role of the counterparty to the Carrefour forward contract. To motivate the example, the instructor can encourage the student to come up with a one–year forward rate off the top of their head (one that is not the correct forward rate). Once the improper forward rate is established, the instructor can invite another student (the arbitrageur) to propose an investment strategy based on the banker’s forward rate and the prevailing inter-bank rates (Exhibit 8). Suppose the banker selects a forward rate of CHF1.5/EUR as the one-year forward rate. Since this rate is well above the proper forward rate of 1.419, the appropriate arbitrage strategy is to
-4Now
Borrow CHF1,000 at 1.125%
Convert the proceeds into euros at the spot rate of 1.453 and invest EUR688 at 3.514%
In one year
Collect the EUR712 at maturity [EUR688(1 + 3.514%)]
Convert the proceeds into francs at the forward rate of 1.5 to give CHF1,068
Payoff the franc loan of CHF1,011 [CHF1,000(1 + 1.125%)]
Keep the difference of CHF57 from the arbitrage trade [CHF1,068 − CHF1,011]
Since this trade is risk-free, the arbitrageur is likely to be motivated to put more money into this trade than CHF1,000. In determining forward rates, the students should come to recognize that a fair forward rate is likely to avoid such arbitrage opportunities and reflect a condition of interest-rate parity. If franc interest rates are lower than euro interest rates, parity requires the franc/euro forward rate to impound franc appreciation that offsets the interest-rate difference. This discussion motivates the interest-rate parity condition: (1 RCHF ,T )T T f CHF / EUR sCHF / EUR (1 REUR,T )T where fCHF/EUR is the T-period franc-to-euro forward exchange rate, SCHF/EUR is the prevailing franc-to-euro spot exchange rate, and RCHF,T and REUR,T are the T-period inter-bank interest rate for the franc and euro, respectively. Since the late 1980s, foreign-currency obligations of this nature are hedged in the swap market. The typical swap hedge entails a package of three swap contracts. The first swap contract is a foreigncurrency interest-rate swap that exchanges fixed-rate payments for floating-rate payments. The swap contract is quoted as the fixed rate (e.g., 6%) over the maturity of the swap (e.g., 10 years). The second swap is a currency swap contract that exchanges the foreign-currency floating rate for the domesticcurrency floating rate. Lastly, the party exchanges the domestic-currency floating rate for the fixed rate using another interest-rate swap, but this time in the domestic currency. The package of swaps generates a contract that takes a fixed-rate obligation in one currency into a fixed-rate obligation in another currency. Using the three-swap package provides more flexibility in achieving more combinations of currency and maturity hedges with fewer numbers of specific contracts. Reviewing the mechanics of swap contracts may be beyond the scope of an introductory class.
-54. Using the parity forward rates, what is the cost of borrowing in Swiss francs? British pounds? U.S. dollars? What should Carrefour do? Exhibit TN1 shows the calculations required to determine the debt cash flows in euros of the various currency bonds. Because the calculations of the forward rates are tedious, the instructor may choose simply to focus on the forward rates for years 1 and 10. Because the difference between borrowing rates varies over the yield curve, the forward-rate calculations are based on the respective swap-curve maturities. Once the forward rates are calculated, the debt cash flows in euros can be computed as the foreign-currency obligation divided by the forward rate. The internal rate of return for the debt cash flows finally captures the euro borrowing cost of 5.25% in euros, 5.03% in pounds, 5.24% in francs, and 5.28% in dollars. The similarity of the euro-based borrowing rates can be used to emphasize that nominal coupon rates mean little. Without knowing the schedule of forward rates, it is impossible to say that the franc is a “no-brainer” or that the U.S. dollar is a “nonstarter.” Barring other considerations, the British-pound issue is materially preferable to the alternatives, with a small but meaningful savings in covered borrowing costs. In a EUR750 million offering, the 0.22% borrowing-rate difference represents an annual reduction in financing costs of EUR1.65 million.2 The difference in borrowing costs represents a quasi-arbitrage opportunity for Carrefour and other borrowers. Epilogue On September 17, 2002, Carrefour issued a GBP500 million 10-year eurobond at 5⅜. Carrefour paid joint underwriters Morgan Stanley and UBS-Warburg a 3.25% gross spread on the deal and a 0.125% selling concession. Concurrently, Carrefour hedged the currency risk with a portfolio of currency and interest rate swap contracts. During the subsequent year the pound depreciated about 10% against the euro.
2 The borrowing-cost difference of EUR1.65 million is calculated as EUR750 million × (5.25% − 5.03%).
-6Exhibit TN1 CARREFOUR S.A. Debt Cash Flows in Target Currency and Euros (in millions)
Debt Cash Flows in Target Currency EUR
Forward Rates
GBP
CHF
USD
0 750.00
471.00
1089.75
735.00
0.628
1.453
1 (39.38)
(25.32)
(39.50)
(40.43)
0.633
2 (39.38)
(25.32)
(39.50)
(40.43)
3 (39.38)
(25.32)
(39.50)
4 (39.38)
(25.32)
5 (39.38)
Debt Cash Flows in Euros EUR
GBP
CHF
USD
0.98
750.00
750.00
750.00
750.00
1.419
0.967
(39.38)
(40.02)
(27.83)
(41.82)
0.638
1.395
0.96
(39.38)
(39.69)
(28.32)
(42.10)
(40.43)
0.643
1.373
0.961
(39.38)
(39.40)
(28.76)
(42.07)
(39.50)
(40.43)
0.646
1.353
0.964
(39.38)
(39.18)
(29.20)
(41.92)
(25.32)
(39.50)
(40.43)
0.648
1.333
0.97
(39.38)
(39.06)
(29.63)
(41.69)
6 (39.38)
(25.32)
(39.50)
(40.43)
0.648
1.314
0.976
(39.38)
(39.04)
(30.06)
(41.41)
7 (39.38)
(25.32)
(39.50)
(40.43)
0.648
1.296
0.984
(39.38)
(39.06)
(30.48)
(41.10)
8 (39.38)
(25.32)
(39.50)
(40.43)
0.648
1.279
0.991
(39.38)
(39.10)
(30.89)
(40.77)
9 (39.38)
(25.32)
(39.50)
(40.43)
0.647
1.263
1.001
(39.38)
(39.15)
(31.28)
(40.39)
(789.38 (496.32 (775.43 (1129.25) ) ) )
0.645
1.248
1.011
(789.38 (769.07 (904.99 (767.10) ) ) )
10
Borrowing rate 5.25%
5.38%
3.63%
5.50%
GBP/EUR CHF/EUR USD/EUR
IRR 5.25%
5.03%
5.24%
5.28%
-7Exhibit TN2 CARREFOUR S.A. Payoff Diagram of Debt Obligation in Euros
Payof in EUR
0 CHF /EUR
−750 m EUR obligation CHF obligation
-8Exhibit TN3 CARREFOUR S.A. Payoff Diagram of Debt Obligation and Forward Contract in Euros
Gain on forward contract 0 CHF/EUR
−750 m
Net position EUR obligation CHF obligation
