There are two somewhat related concepts (currency differences and country risk) that could have an impact on the comparability of interest rate pricing data obtained from comparable USD loans made to US borrowers when pricing a foreign currency denominated intercompany loan made to a foreign based related-party borrower.
This tutorial deals with the concept of making a comparability adjustment for the difference in the currency of the tested loan to the currency of the comparable loan transactions, which is usually USD. (For the country risk concept see the EdgarStat "Tutorial: Country Risk Adjustments in Intercompany Financing”).
As a reminder, the corporate loan interest rate is the sum of the lender’s funding costs (or cost of funds, or COF%) and the spread required to compensate the lender for making the loan and taking on the credit risk related to the borrower’s loan (i.e., the lending margin, or LM%). Stated as the following formula:
IRate% = COF% + LM%
Financial economic theory states that there is a relationship between interest rates and foreign exchange rates of one country compared to another country. This is the Interest Rate Parity (IRP) theorem.
NOTE: For further information see the IRS’s APA Training Manual which provides a description of the interest rate parity (IRP) concept. In “Adjustment for Changes in Exchange Rates During an APA Term”, dated May 9, 2002, the IRP topic is covered in Section II 1. Determinants of Exchange Rates and FX Volatility, subsection 1(b) Covered Interest Rate Parity (CIP).
In brief, it states that in a market without arbitrage, the expected change in the exchange rate between two country’s currencies (i.e., forward premium or discount to the spot exchange rate) is equal to the percentage difference between the risk-free nominal interest rate between the two countries. Therefore, the IRP theorem is the basis upon which to estimate the interest rate adjustment, if any, for differences in the currency of the comparables, which are usually in USD, to the non-USD currency of a particular tested intercompany loan.
Applying the concept of the IRP theorem is one approach used to quantify a comparability adjustment for the difference in currencies. Essentially the concept of IRP is used to determine the equivalent interest rate that a lender would need to charge for a loan denominated in the tested loan’s currency compared to the observed interest rates in the currency of the comparable loan transactions (which have the same credit risk profile as the tested borrower’s loan) such that the lender would have the equivalent interest rate return. This is the principle behind the interest rate parity (IRP) theorem. The formula is as follows:
(1+i_{x} ) = (F_{x⁄y }/ S_{x⁄y})×(1+i_{y} ), where
i_{x }= Interest Rate for Currency x
F_{x⁄y }= Forward Exchange Rate x⁄y
S _{x⁄y} = Forward Exchange Rate x⁄y
i_{y} = Interest Rate for Currency y
As an example, assume that on July 23, 2021 a lender would be willing to make a 1-year USD 100 million loan to a Baa3/BBB- borrower at 1-yr. USD LIBOR + 150 bps (which is, as of July 23, 2021, an interest rate of 1.744%, or rounded to 174 bps).
However, the borrower wishes that the loan be made in EUR. The lender would get an equivalent return (interest) if the USD loan amount was converted to EUR at the spot rate with the 1-yr. EUR loan having an interest rate of 0.92%, or 92 bps, and a currency swap to convert back to USD at the end of the loan maturity. Th 92 bps is a calculated interest rate to achieve an equivalent return to the lender. To have a covered position, the lender/borrower would enter into a one-year currency swap at the one-year forward exchange rate to convert the EUR amount of the loan proceeds (principal plus interest) back into USD. This means that the lender earns an equivalent amount at the end of one year based on an interest rate of 0.92% for a EUR denominated loan as it would if it had made the original USD loan at an interest rate of 1.74%.
The following is the application of the IRP formulae to this example:
i_{y} (USD Interest Rate) |
0.01744 |
(1+i_{y} ) |
1.01744 |
F_{x⁄y } |
0.84324 |
S_{x⁄y} |
0.85012 |
(F_{x⁄y }/ S_{x⁄y}) |
0.99190 |
(1+i_{x} ) = (F_{x⁄y }/ S_{x⁄y})×(1+i_{y} ) |
1.00920 |
i_{x} (EUR Interest Rate) |
0.00920 |
The following verifies that a EUR denominated loan at 0.92% (or 92 bps) is equivalent to a USD denominated loan at 1.744% (or 174.4 bps).
Converts USD to Lend in EUR |
€ 85,012,330 |
Earns Interest at 1-Yr. Rate |
0.92% |
Interest Income for 1-Yr. |
€ 782,430 |
Total Repaid by Borrower at End of 1 Yr. |
€ 85,794,760 |
Exchange EUR for USD at 1-Yr. Forward Rate |
$101,744,000 |
Lend in USD |
$100,000,000 |
At 1-Yr. Rate |
1.744% |
Interest Income for 1-Yr. |
$1,744,000 |
Total |
$101.744,000 |
Thus, in this example, the comparability adjustment for the difference in currency would be to reduce the USD denominated interest rate (i.e., the 1Y USD LIBOR + LM) by 82 bps (i.e., 1.74% - 0.92% = 0.82%) for the EUR denominated loan. This EUR interest rate is the sum of the EUR-based proxy for the lender’s COF% plus an LM. The selection of the appropriate market reference rate, or COF% proxy, for the EUR loan could be either 12M EURIBOR or the 12M EUR LIBOR. In this example, as of July 23, 2021, the 12M EURIBOR was selected and was a negative 0.49% (rounded).
With an interest rate (12M EURIBOR + LM) of 92 bps the LM would have been 141 bps (i.e., -0.49% - 0.92% = 1.41%, or 141 bps). The LM adjustment, after selecting the currency specific market reference rate, is 9 bps (i.e., 150 bps – 141 bps).
NOTE: In 2020 CUFTanalytics performed an analysis of corporate loan transactions with multi-currency options – mainly currencies such as USD, EUR, GBP, AUD, CAD, CHF, JPY, etc. - that were evidenced in credit agreements filed with the US SEC. There is market evidence that the lending margin (LM) is identical for the alternative currency denominated loans as for the USD denominated loans, that were made to the same borrower in the same credit agreement. Thus, there is an argument that, for these alternative currencies, no adjustment to the lending margin would be required (only to the currency-specific, maturity-specific market reference rate). However, there is insufficient market data in the database for other “non-USD” currency denominated loans for this argument to be considered. Subscribers to EdgarStat's CUFT Loan Agreements Database can replicate this research.
As can be seen in the preceding example most of the 82 bps change in the interest rate is attributable to the change in the currency-specific market reference rates (i.e., 12M USD LIBOR = 0.244%; 12M EURIBOR negative 0.49%, for difference of 0.734%, or 73 bps, rounded). Thus, the most significant currency adjustment is made automatically by selecting the most appropriate market reference rate.
NOTE: As of December 31. 2021 the LIBOR based settings for GBP, EUR, CHF, and JPY LIBOR (along with 1-week and 2-month USD LIBOR) ceased to be used for new contracts. While 1-month, 3-month and 6-month USD LIBOR rates are still available these will be ceased on June 30, 2023. New contracts will be conducted in Alternative Reference Rates (ARR) such as SOFR for USD, SONIA for GBP, CORRA for CAD, SARON for CHF, etc. As a transitional measure, fall back rates have been published as an adjustment to the specific ARRs to make them equivalent to the corresponding historical LIBOR.
If there is no market reference rate for the currency of the tested intercompany loan, then the next best option could be to consider a currency-specific and maturity-specific risk-free rate as a proxy for the lender’s cost of funds. The yield on the appropriate government bonds would be an imperfect but close proxy for a lender’s cost of funds. By applying the IRP concept, the equivalent currency-specific, maturity-specific interest rate can be calculated from the USD denominated interest rates of the comparables.