0:12

Let's talk about these alternatives and

Â we're going to start with the previous example.

Â In fact, that previous example has an almost trivial solution.

Â Let me remind you what we're talking about.

Â We're having this company that expects to borrow in 3 months.

Â The current rate is 3%.

Â And the company is concerned about the risk that

Â interest rates will go up, right?

Â What's the previous solution?

Â You can issue the commercial paper today.

Â Maybe you've thought about that already, right?

Â Why is the professor talking about this,

Â it seems like this is what the company should do is borrow today.

Â You are right.

Â That is in fact a good solution to this problem.

Â What happens is, in this case, you'll pay 3%.

Â No matter what happens to interest rates.

Â 1:12

Here it is.

Â The company needs to hold cash.

Â That's why this lecture is about liquidity, okay?

Â In order for these alternatives to work,

Â the company's going to have to hold the cash, right, instead of spending it.

Â 1:28

because we have a financial planning model in the background that

Â tells us we're going to need cash in three months.

Â If you borrow today and spend it, you're going to need to borrow again.

Â The hedging is gone, right?

Â So that's why it's liquidity that is a substitute for hedging.

Â You need to hold cash if you want to hedge in the right way.

Â And, as we're going to see,

Â that's going to be a general principle we're going to learn in this lecture.

Â Okay, the company has to hold the cash.

Â And, of course, that is going to introduce potential risks.

Â 2:03

You have to invest in a safe asset, right?

Â Because you want to make sure you're going to have the money.

Â So you shouldn't be buying risky equity, for example.

Â The safe asset is likely to produce a low rate of return.

Â You're going to pay a liquidity premium, right?

Â 2:19

The interest payment that you receive on your safe asset,

Â it may be low but it's taxable, so

Â there's going to be a tax deal, right, that you have to take into account.

Â And finally, I don't want to take for

Â granted that the company will keep the cash.

Â Once you put the money in the company,

Â the CEO may be tempted to spend the cash instead of hoarding it.

Â So that may introduce problems as we already discussed it in this course,

Â cash can burn a hole in the pockets so companies could be tempted to overspend.

Â All right, we talked about this when we discussed the payout policy for

Â example, right?

Â 2:55

Because of all of these problems,

Â hedging with liquidity is also going to be imperfect.

Â Let me give you another example.

Â And this is a really cool one, I think.

Â That's actually going to show you why I choose December 14 for

Â the Russian example, okay?

Â So, now we go back to our US company that needs to make that rouble payment, right?

Â It's in December 15, so it's in one year.

Â And remember that the company's concern is that the roubles may appreciate

Â relative to the dollar, so the company is proposing to enter a forward contract

Â at that amount that guarantees a payment of 3.4 whatever, right?

Â In one year, you got the idea, we did this already.

Â Let's think about a situation when the forward was not available,

Â which is totally possible for smaller countries, right?

Â If you have a payment that is due in a longer time period, or maybe,

Â because of settlement risk you may not be able to buy a forward contract.

Â So, what the company can do is to buy roubles in the stock market.

Â You can buy the roubles today.

Â The same idea as the interest rate example.

Â Instead of buying roubles tomorrow, you can buy them today.

Â That is also going to eliminate your exchange rate risk,

Â as we're going to show next, right?

Â If you look at the table that I gave you from the Financial Times,

Â the current exchange rate is 55.667.

Â That's the current rate at which you could buy roubles at December 2014.

Â So now let me ask you this question.

Â What does the US company need to do with the roubles?

Â Think about that.

Â 4:36

It has to invest in a safe asset, but the asset has to be in roubles.

Â If you have roubles and you changed them back into dollars, when that year

Â comes you're going to have to buy roubles again, so it didn't work, right?

Â In this case, the hedging position requires you to hold cash in roubles.

Â I hope you got that answer.

Â Let's develop that, how would that work?

Â We have to think about what the interest rates were.

Â So at that time, the 1-year interest rate on a Russian government bond was 16.8%,

Â while the rate on a 1-year US T-bill was just 0.2%.

Â T-bill rates has been very low in the US, as you probably know.

Â So how many roubles does the company need to buy?

Â That's what this equation is doing here for you.

Â You need 200 roubles in one year, right?

Â So if you invest at 16.8%, that means you're

Â going to buy 171.244 million roubles, right?

Â So you don't have to quite buy 200 because you can invest in roubles and

Â you're going to earn the interest, right?

Â So that's the amount, a simple discounting problem.

Â So, that money turns into 200 million roubles in one year.

Â Right, how much does that take to buy that today given the current exchange rate,

Â which is here?

Â That's going to take you 3.076 million dollars.

Â So it's approximately 3 million dollars, right?

Â If the company does this transaction, think about this,

Â your hedged against exchange rate risk.

Â You changed dollars into roubles today.

Â You hold the roubles, right?

Â In one year, you can use the roubles to make the payment.

Â You're done.

Â Again, liquidity substitutes for hedging, right?

Â 6:29

There are a few things here that you may be worried about.

Â The first one is not a problem, all right?

Â The amounts are different.

Â So now we are spending 3.076 today instead of 3.082 tomorrow,

Â as we were doing before with the forward contract, right?

Â 3.082 is the amount you're spending if you're hedging the risk with the forward

Â contract.

Â Is this the same amount?

Â The answer is yes, because if you had invested

Â the the 3.076 today in a treasury bill,

Â you would get exactly 3.082 tomorrow, okay?

Â So, that's how I put the numbers actually.

Â 7:09

What I used here is the notion of interest rate parity.

Â I actually assumed that the interest rates where such that interest rate

Â parity exactly worked.

Â Essentially what the interest rate parity means is that

Â the relationship between the futures and the spot rate has to be the same

Â as the relationship between the interest rates on two different currencies.

Â All right, this is not really a topic of corporate finance, but I want to mention

Â it here just to clarify this example, and the idea is that investors should

Â be indifferent between investing in dollars or investing in roubles.

Â If investors are perfectly indifferent, then interest rate parity should work.

Â 7:51

The problem is, of course,

Â the real world is always more complicated than our example, right?

Â The actual one year Russian government bond rate was not 16.8%.

Â I made up that number, I was cheating, okay?

Â The actual rate was 15.6 in December 14.

Â So, in order to have 200 million roubles in one year,

Â the US company would actually have to spend more money.

Â It would have to spend a little bit more money, which then, if you do the math,

Â that would be equivalent to $3.109 million, which is actually going to be

Â more than what you would have spend with the forward contract.

Â So hedging with liquidity is going to have this cost, okay?

Â 8:34

That's not the end of it.

Â Now comes, actually, the most interesting discussion.

Â That's why I have the picture of the Russian government there, right?

Â Letâ€™s think about what was happening in Russia at the end of 2014.

Â Why was the Russian one-year rate, 17% is extremely high, right?

Â For a one-year government bond rate.

Â What was going on?

Â 8:58

What was happening is that Russia was in the middle of a currency crisis.

Â On December 15th of 2014, as this actually comes from an article

Â from The Economist, the currency lost 10% of its value in one day.

Â [LAUGH] It had already lost 40% on that year, so what the central bank did

Â is increase the interest rates sharply to try to calm the market.

Â But there was desperation according to the economists, okay?

Â So we are in the middle of a crisis and my hedging strategy seems very smart,

Â but what I'm proposing is that the US company is going to invest in Russia.

Â What's the problem?

Â The problem is that Russian bonds were probably not risk free at the end of 2014,

Â right?

Â The US company maybe eliminates currency risk by doing that,

Â but now you're exposed to significant credit risk.

Â 9:58

You have Russian bonds.

Â Russian bonds at that time were a very risky security,

Â probably have a low credit rating.

Â We talked about credit ratings already, right?

Â So that is going to create significant credit risk.

Â Currency risk turns into credit risk.

Â So, again, that's another problem of trying to use liquidity to hedge,

Â you may not have the right asset,

Â the safe asset that you need to get a perfect hedging strategy.

Â Now the company needs to think about,

Â is it really worthwhile hedging using Russian bonds or not?

Â And the answer is not obvious, right?

Â So that's the summary.

Â Liquidity is always a possible alternative.

Â It's always an alternative.

Â Theoretically, at least, you can always think about a liquidity alternative, but

Â you also have to consider the cost, okay?

Â Liquidity will typically come with additional costs and risks.

Â There is going to be a cost of carrying cash,

Â there may be interest payments that are taxable.

Â Interest parity may not hold if this is currency risk.

Â And finally, as we discussed, you may introduce some credit

Â risk in your strategy, which you have to think about to make sure

Â that it's really worth using liquidity to hedge, okay?

Â The bottom line, it's always difficult to give overall conclusions,

Â but I think here the picture is pretty clear.

Â The bottom line is that if a derivative is available, my guess is that it will

Â probably be safer and cheaper, think about the Russia example.

Â You could go in the forward market with an international bank that is a fairly

Â reliable counter party and write a forward contract.

Â You're not going to have to hold Russian bonds, etc, right?

Â So that might be safer.

Â It may be also be cheaper,

Â because you don't have the other cost of holding liquidity.

Â 11:50

But in some cases, a derivative is not available.

Â That's the commercial paper example, right?

Â In that case, the best we could do is to have an imperfect hedge.

Â And it seems very straightforward to borrow today instead of waiting for

Â tomorrow.

Â So in that case, liquidity may be a better tool.

Â So I want you to always think about liquidity, but remember that

Â if the derivative is available, it might actually be the way to go.

Â