FORD MOTOR CREDIT COMPANY SUGGESTED ANSWERS by Rchard M. Levch New York Unversty Stern School of Busness Revsed, February 1999 1
SETTING UP THE PROBLEM The bond s beng sold to Swss nvestors for a prce of SF 5,000. Therefore, the bond must be evaluated n terms of Swss francs. Note the tombstone the bond has a Swss Securty Number and s restrcted for sale n the U.S.A. Ths affects your analyss. To begn, wrte down the cash flows that accrue to the owner of the bond. Frst, there s the outflow of SF 5,000 upon purchase of the bond n year zero. Then 5.5% of SF 5,000 (or SF 25) n years 1-, plus SF 2,000 n year seven. Then.5% of $2,000 (or $150) n years 8-15, plus $2,000 n year 15. The cash flows correspondng to years 1-15 appear n the top row of the attached spreadsheets labeled "base case." The value of the bond s the net present value of the cash flows n years 1-15. The case tells us s the dscount rate for an equvalent -year SF bond s 4.5% so the SF cash flows n years 1- can be dscounted at 4.5%,. The US$ cash flows n years 8-15 must be converted to SF fgures at some unknown expected spot rate, and then dscounted at the unknown SF dscount rate for cash flows n years 8-15. The overall formula would be as follows:.055 2/5 PRESENT VALUE = SF5,000 { + (1+.045 ) (1+.045 ) =1 } 15. 05 Et S t+ + Et S t+15 + $2,000 { 15 =8 (1+ d SF ) (1+ d SF ) } If the Swss nvestor beleves that exchange rate expectatons are governed by uncovered nterest party (.e. Fsher Open), then the bond can be prced n ether of three ways as shown below. However, f the Swss nvestor s rsk averse, then a hgher dscount rate wll be requred for the uncertan SF cash flows n years 8-15, thus lowerng the prce of the bond. If we beleve that the Swss nvestor s rsk-averse, then uncovered nterest party produces an upper bound for the prce the Swss nvestor s wllng to pay. Only f the Swss nvestor s more bullsh about the US$ n years 8-15 wll the bond be worth more than n the base case. 2
METHOD 1: The Swss nvestor can use uncovered nterest party to solve for both of the two unknown factors the Swss dscount rate and the expected future spot exchange rate. Et S (1+d t+ SF ) = S t (1+d $ ) The case tells us that the ntal exchange rate (St) s 1.5 SF/$ and the dscount rate on a smlar 15-year US$ bond s 8.0%. METHOD 2: Estmate the expected future SF/$ spot exchange rates and dscount the expected SF amounts at an approprate SF dscount rate. Assume that the 1- year Swss franc dscount rate (4.5%) apples to the 8-15 year perod as well. Then we have: E t S t+ = S t(1+ g t ) where g t = (1+.045) (1+.08) = - 3.2% Notce that when we substtute EtSt+1 nto our cash flow equaton, the 0.045 cancels out of the US$ cash flows, so ths s really the same as the frst method. Notce that we use market nterest rates, and not coupon rates. The pont here s that n year 15 (to take one example), uncovered nterest party predcts that the SF/$ exchange rate wll be SF 1.50 x (1.045/1.08) 15 = SF 0.9151/$. The US$ dollar nflow of $2150 n ths perod s expected to be worth (from the Swss pont of vew) SF 1,96.46. If ths cash flow s dscounted at an nterest rate of 4.5%, the present value of ths cash flow s SF 1,016, just as t appears under year 15 n the frst method. Method 2 gves us the "glde path" of the SF/US$ rate (smlar to Fgure 5.11 n the textbook). For years 8-15, the break-even exchange rate values are: Year 8: SF 1.50 x (1.045/1.08) 8 = SF 1.1525/$ Year 9: SF 1.50 x (1.045/1.08) 9 = SF 1.1151/$ Year 10: SF 1.50 x (1.045/1.08) 10 = SF 1.090/$ Year 11: SF 1.50 x (1.045/1.08) 11 = SF 1.0440/$ Year 12: SF 1.50 x (1.045/1.08) 12 = SF 1.0102/$ Year 13: SF 1.50 x (1.045/1.08) 13 = SF 0.94/$ Year 14: SF 1.50 x (1.045/1.08) 14 = SF 0.9458/$ Year 15: SF 1.50 x (1.045/1.08) 15 = SF 0.9151/$ If the SF s expected to be weaker than the above path, then the MUST bond wll be more valuable to Swss nvestors than what we computed n the base case. 3
METHOD 3: Value the bond as the sum of two ndvdual bonds frst, a seven-year SF bond wth known SF cash flows and a known SF dscount rate and second, a US$ bond wth cash flows n years 8-15 and a known US$ dscount rate for those perods. The value of the frst seven-year SF bond s:.055 2/5 SF 3090.15 = SF5,000{ + (1+.045 ) (1+.045 ) =1 } The value of the second ffteen-year US$ bond s: 15. 05 1 $1,133.45 = $2,000 { + 15 (1+. 08 ) (1+. 8 ) =8 0 } A Swss nvestor who s rsk neutral would pay SF 100.1 for the second bond, whch s smply the $1,133.45 value of the second bond tmes the spot exchange rate of 1.50 SF/US$. Vrtually anyone would exchange $1,133.45 for SF 100.1 on the offerng date, snce ths exchange matches the ntal spot exchange rate. But only a rsk neutral Swss nvestor would exchange $1,133.45 today for the US$ cash flows stpulated n perods 8-15, because the future spot exchange rates are uncertan. Rsk-averse Swss nvestors would place a lower value on the US$ bond. [In ths context, rsk-neutral Swss nvestors means that Swss nvestors gnore exchange rate rsk, as they use the same dscount rate (8%) to dscount US$ cash flows as an Amercan uses.] 4
QUESTIONS AND ANSWERS: 1. a. Descrbe the technque or approach that you would use to value ths bond. The bond should be valued usng the dscounted cash flow approach. Valuaton requres the determnaton of SF cash flows, the future SF/$ exchange rates, and dscount rates for both US$ and SF cash flows. b. What monetary value would you place on the bond on the day of ssue (May 14, 198)? Takng the base case of uncovered nterest party descrbed above, the value of the bond s SF 490.32 as shown usng the three methods on the attached page. 2. a. Is ths bond a "good deal" for Ford Motor Credt Corporaton? Explan why or why not. Ths bond appears to be a "good deal" for Ford Motor. They are rasng SF 5,000 n captal and returnng cash flows valued at only SF 490. To be more precse, Ford must pay the bond underwrters, say 1%, so they are only rasng about SF 4,950. The case suggests that Ford could have rased 15-year US$ funds at a rate of about 8%. After the swap, we presume that Ford's US$ costs are lower. b. Is ths bond a "good deal" for the nvestor? Explan why or why not. Smlarly, on the surface of thngs the bond does not seem lke a good deal for the nvestor. The nvestor pays SF 5,000 for cash flows valued at only SF 4,90. The nvestor earns an extra 1% (compared to market rates) n the frst seven years, but earns 1/2% less n the last eght years. The bond s only good for the nvestor f ths s the most cost effectve way for hm to bet on a "relatvely weak SF" n years 8-15, or to hedge future cash outflows. See the next answer for more on ths. 3. a. What type of nvestor would be nterested n the Ford MUST bond? To begn, ths s a long-term asset wth good credt rsk. The bond offers SF cash flows n the frst seven years wth US$ cash flows n the fnal eght years. An nvestor/hedger who wants to hedge SF cash outflows n the early years and US$ cash outflows (from a US retrement, US vacatons, or chldren gong to US schools) could be attracted to ths bond. An nvestor/speculator could be attracted to the Ford MUST bond based on a scenaro that the US$ was under-valued n 198 and would probably strengthen n the longer run. Another scenaro could be that the US$-SF nterest dfferental (at 3.5%) ncluded some rsk-premum on the US$ so that the US$ was unlkely to deprecate by the full 3.5% per year for 15 years thus makng t possble for a Swss nvestor to earn the rsk premum by holdng US$ assets. 5
You should be clear that (a) havng a hedgng demand for SF and US$ cash flows as n the Ford MUST bond or (b) havng speculatve expectatons for a stronger US$ n years 8-15 are not suffcent reasons to buy the Ford MUST bond. A Swss nvestor could buy these cash flows by purchasng one -year SF bond and purchasng eght US$ zero coupon bonds wth cash flows that replcate the Ford MUST bond n years 8-15. A Swss retal nvestor mght fnd t dffcult (meanng nconvenent, or somewhat costly) to replcate the cash flows of the Ford MUST bond. More over, the Swss nvestor mght be subject to addtonal government dsclosures and tax lablty f the eght US$ zero coupon bonds were purchased n the U.S. Thus, the Swss nvestor mght be wllng to pay a bt extra for the convenence of havng the SF and US$ cash flows bundled together n the Ford MUST bond, and prced n SF through a Swss frm. b. What are the rsks and benefts to the nvestor who buys the bond? The fundamental rsk facng the Swss nvestor s the exchange rate rsk of the US$ cash flows n year 8-15. The nvestor naturally faces nterest rate rsk over the holdng perod of the bond. The major benefts are exposure to potentally desrable cash flows (for hedgng or speculaton), convenence of havng the SF and US$ cash flows bundled together, and an ssuer wth hgh credt qualty. c. What expectatons would the nvestor have who decdes to buy ths bond? The nvestor who buys the Ford MUST bond expects the US$ to be stronger n years 8-15 than the rate mpled by the 3.5% nterest dfferental. 4. The spot exchange rates on the annversary dates of the bond were roughly as follows: May 14, 1988 May 14, 1989 May 14, 1990 May 14, 1991 May 14, 1992 May 14, 1993 May 14, 1994 May 14, 1995 May 14, 1996 May 14, 199 May 14, 1998 1.445 SFr/$ 1.14 SFr/$ 1.431 SFr/$ 1.485 SFr/$ 1.456 SFr/$ 1.418 SFr/$ 1.403 SFr/$ Year : Converson Year 1.16 SFr/$ Year 8: Frst annual US$ coupon 1.254 SFr/$ Year 9: Second annual US$ coupon 1.440 SFr/$ Year 10: Thrd annual US$ coupon 1.484 SFr/$ Year 11: Fourth annual US$ coupon In general, dd these exchange rates serve to make the realzed return on the 6
Ford MUST bond hgher or lower than they ntally expected (for Swss nvestors)? Explan why or why not. Recall that the glde path estmates were Year 8: SF 1.50 x (1.045/1.08) 8 = SF 1.1525/$ Year 9: SF 1.50 x (1.045/1.08) 9 = SF 1.1151/$ Year 10: SF 1.50 x (1.045/1.08) 10 = SF 1.090/$ Year 11: SF 1.50 x (1.045/1.08) 11 = SF 1.0440/$ Year 12: SF 1.50 x (1.045/1.08) 12 = SF 1.0102/$ Year 13: SF 1.50 x (1.045/1.08) 13 = SF 0.94/$ Year 14: SF 1.50 x (1.045/1.08) 14 = SF 0.9458/$ Year 15: SF 1.50 x (1.045/1.08) 15 = SF 0.9151/$ So n year 8, the exchange rate was almost exactly where we had predcted t to be on the bass of nterest rates 8 years before! Actually, the Swss nvestor receved about 1.25% more (1.16 rather than 1.1525) for hs US$ coupon n year 8 than was predcted. But n 1996 (year 9) and agan n 199 (year 10) the US$ strengthened aganst the SFr. In year 9, the Swss nvestor receved about 12.5% more (1.254 rather than 1.1151) than was predcted. And n 10, the Swss nvestor receved about 33.5% more (1.440 rather than 1.09) than was predcted. So the Swss nvestor appears on the way to gettng a hgher yeld n terms of Swss francs than he orgnally expected. Ex post, the Swss nvestor appears to have benefted by purchasng a bond wth a US$ component, where the US$ nterest rate provded a greater offset than necessary for the realzed deprecaton of the US$.
Post Scrpt: Yet another reason to thnk that the bond may be overvalued s suggested n the followng pcture representng the term structure of nterest rates. Yeld 8.0% US$ 4.5% SFr yrs 15 yrs Tme to Maturty Usng the 4.5% nterest rate to dscount the -year SFr bond may understate the dscount rate that s approprate for years 8-15 for SFr cash flows. The under estmate of the approprate dscount rate depends on the curvature of the term structure at years 8-15. Very lkely, the Swss term structure s very flat at the long end. If the approprate for years 8-15 for SFr cash flows s 4.5%, then the value of the Ford MUST bond s less than 4,90. However, f the SFr nterest rate at 15 years s 4.5%, then the SFr/US$ exchange rate wll deprecate less dramatcally (at a rate governed by [1.045/1.08] n ) whch adds value to the bond n SFr terms. 8
Valuaton of Ford Motor Credt MUST Bond -- Base Case -- Method #1: Use the present spot rate and US$ dscount rates Perod 1 2 3 4 5 6 8 9 10 11 12 13 14 15 Swss franc cash flows... US $ cash flows... Cash Flow 25 25 25 25 25 25 225 150 150 150 150 150 150 150 2150 Spot SF/$ 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 Net SF CF 25 25 25 25 25 25 225 225 225 225 225 225 225 225 3225 [SF] 0.045 0.045 0.045 0.045 0.045 0.045 0.045 [$] 0.080 0.080 0.080 0.080 0.080 0.080 0.080 0.080 Dscount Factor 1.045 1.092 1.141 1.193 1.246 1.302 1.361 1.851 1.999 2.159 2.332 2.518 2.20 2.93 3.12 Dscounted Cash Flow 263.16 251.83 240.98 230.60 220.6 211.1 161.3 121.56 112.56 104.22 96.50 89.35 82.3 6.60 1016.65 Sum DCF 490.32 Swss francs Valuaton of Ford Motor Credt MUST Bond -- Base Case -- Method #2: Expected glde path of the SF/$ rate Perod 1 2 3 4 5 6 8 9 10 11 12 13 14 15 Swss franc cash flows... US $ cash flows... Cash Flow 25 25 25 25 25 25 225 150 150 150 150 150 150 150 2150 Expected Spot SF/$ 1.1525 1.1151 1.090 1.0440 1.0102 0.94 0.9458 0.9151 Exp. SF CF 25 25 25 25 25 25 225 12.8 16.2 161.85 156.60 151.53 146.62 141.8 196.51 [SF] 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 Dscount Factor 1.045 1.092 1.141 1.193 1.246 1.302 1.361 1.422 1.486 1.553 1.623 1.696 1.2 1.852 1.935 Dscounted Cash Flow 263.16 251.83 240.98 230.60 220.6 211.1 161.3 121.56 112.56 104.22 96.50 89.35 82.3 6.60 1016.65 Sum DCF 490.32 Swss francs Valuaton of Ford Motor Credt MUST Bond -- Base Case -- Method #3: MUST Bond as sum of two ndvdual bonds Perod 0 1 2 3 4 5 6 8 9 10 11 12 13 14 15 Swss franc cash flows... US $ cash flows... Cash Flow 25 25 25 25 25 25 225 150 150 150 150 150 150 150 2150 [SF] 0.045 0.045 0.045 0.045 0.045 0.045 0.045 [$] 0.080 0.080 0.080 0.080 0.080 0.080 0.080 0.080 Dscount Factor 1.045 1.092 1.141 1.193 1.246 1.302 1.361 1.851 1.999 2.159 2.332 2.518 2.20 2.93 3.12 Dscounted SF Cash Flow 3090.15 263.16 251.83 240.98 230.60 220.6 211.1 161.3 Dscounted US$ Cash Flow $1,133.45 $81.04 $5.04 $69.48 $64.33 $59.5 $55.15 $51.0 $6. x1.50 SF/$ 100.1 Sum DCF 490.32 Swss francs