EECS 1541 Lecture 25: EECS 1541 Lecture 25 Notes
23 Jun 2018
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EECS 1541 Lecture 25 Notes
Introduction
Borrower’s exchange
Borrowers usually prefer that loans be denominated in the currency of their primary in
which they receive most of their cash flows, which eliminates the borrower’s exchange
rate risk.
However, the loan’s interest rate depends on the currency in which the loan is
denominated.
A loan denominated in the currency of a country with very low inflation (such as Japan
or the United States) normally has a relatively low interest rate
Loans denominated in the currency of a country with high inflation rates (such as some
Latin American and Asian countries) tend to have correspondingly higher interest rates.
Hence borrowers subject to high interest rate loans in their domestic currency might
consider borrowing in a low–interest rate currency
Although doing so exposes the borrower to exchange rate risk
Because banks accept short-term deposits and sometimes provide longer-term loans,
their asset and liability maturities do not match.
This misalignment can adversely affect a bank’s performance during periods of rising
interest rates
Since the bank may have locked in a rate on its longer-term loans while the rate it pays
on short-term deposits continues to rise.
In order to avoid this risk, banks commonly use floating rate loans.
The loan rate floats in accordance with the movement of a market interest rate, such as
LIBOR.
For example, a loan that is denominated in a particular currency and is provided by a
bank to an MNC might be structured with an interest rate that resets every six months
to the prevailing LIBOR for that currency plus 3 percent.
Document Summary
Borrowers usually prefer that loans be denominated in the currency of their primary in which they receive most of their cash flows, which eliminates the borrower"s exchange rate risk. International credit market activity has increased over time, yet the growth is mostly concentrated in regions where economic conditions are relatively strong. Those regions tend to have more funds deposited by mncs as well as a strong demand for loans by mncs that are expanding their business. They receive most of their cash flows, which eliminates the borrower"s exchange rate risk. However, the loan"s interest rate depends on the currency in which the loan is denominated. A loan denominated in the currency of a country with very low inflation (such as japan or the united states) normally has a relatively low interest rate. Loans denominated in the currency of a country with high inflation rates (such as some. Latin american and asian countries) tend to have correspondingly higher interest rates.
