Combining Cross-Border Direct Loans and Foreign Exchange Derivatives

By Huang Jun

C ross-border direct loans (CBDL for short)generally refer to a domestic institution(the ‘borrower’) which borrows money from a nonresident.This article refers to CBDL as a banking product: a combination financing arrangement against domestic guarantees. In this kind of financing arrangement, a domestic borrower, as a counter guarantor,applies to a domestic bank (the‘guarantor bank’) to issue a financial guarantee in favor of an overseas bank ( the ‘lending bank’), which may accordingly finance the domestic borrower (or its nominated enterprise)based on such a bank guarantee. The guarantor bank is often the main provider of the finance product,contacting the lending bank and sharing the profits with the lending bank. In consideration of the financing costs, the funds are more likely to be in foreign currency such as US dollars instead of renminbi. The borrower sells the foreign currency to the guarantor bank to get an equivalent amount of renminbi for domestic usage. At maturity, the borrower uses renminbi to purchase foreign currency from the guarantor bank to clear the principal and interest.

The key issue in finance products such as these is cost management.The total cost of the product is comprised of three parts: bank guarantee fees, interest on the loan,and the cost of forex settlements and purchases. When the loan is issued, all costs are known initially except the cost of purchasing forex,determined by the exchange rate at maturity. In order to lock in a total cost, the most commonly used tools are forex derivatives such as forwards and swaps. However, such traditional tools can merely fix the cost, while customized cost management addresses the needs of enterprises according to their risk-cost preference. Taking into account such needs, more comprehensive forex derivatives need to be introduced in CBDL, to help borrowers better manage and even lower their financing costs. This article aims to introduce three types of forex derivatives and emphasizes how they can be used in combination with CBDL, to better facilitate enterprises’cost management.

Cross Currency Swaps

A cross-border direct loan may be medium or long term with interest paid in instalments, such as on a monthly or quarterly basis.That means the borrower needs to purchase forex for interest payments several times. The borrower could purchase forex each time at the spot rate, while he needs to bear the risk from forex rate fluctuations.Alternatively, the borrower could sign several forex forward contracts,though that might be viewed as unnecessarily troublesome. Instead,a cross-currency swap may be a good alternative.

A cross-currency swap is an agreement between a customer and a bank to exchange interest payments and principal on debt or assets denominated in two different currencies. The notional amount is determined by the prevailing forex spot rate and remains constant during the life of the swap. Specifically,under a cross-border direct loan, the borrower may sign a cross-currency swap contract with the guarantor bank. The contract may have an agreement on:

Principal swaps: The borrower initially uses foreign currency funds from a cross-border direct loan to exchange an equivalent amount of renminbi funds with the guarantor bank at a designated exchange rate.At maturity, the borrower uses the same amount of renminbi funds and exchanges them back into foreign currency at the same exchange rate,so that it can repay the principal to the lending bank in a foreign currency.

Interest swaps: Each time an interest payment comes due, the borrower makes a renminbi interest payment to the guarantor bank at an appointed interest rate (different from that of CBDL). Meanwhile, the guarantor bank pays foreign currency interest to the borrower at the same interest rate as that of the loan offered by the lending bank, so that the borrower is able to pay the foreign currency interest to the lending bank.

As a result, the borrower is able to obtain a renminbi loan whereby the principal is repaid in renminbi and the interest is at a renminbi rate.So, here is the key question: Why do banks develop such complicated combination products since it is much more convenient to borrow renminbi from a domestic bank?

This question leads to another important advantage of these combination products: lowering the financing cost. The determinants of a renminbi loan interest rate are essentially different from those of a renminbi interest rate in a cross-currency swap. In fact, the guarantor bank merely exchanges two currencies with equivalent value to the borrower, instead of offering money to that party. The renminbi interest rate of cross-currency swaps is mainly determined by two factors --the actual foreign currency loan rate demanded by the lending bank and the risk premium of future forex rate fluctuation. The two components of the cost, plus the finance guarantee fee, are probably lower than the cost of a domestic renminbi loan.

Non-Deliverable Forwards

Forex forwards are one of the main tools used in CBDL when the borrower hopes to lock in the cost. Before 2018, a client had to actually buy or sell foreign currency at maturity of the forward contract.In February 2018, the State Administration of Foreign Exchange permitted the use of non-deliverable forwards. It is much more convenient for the borrower to choose a better forex forward price when an NDF is combined with a cross-border direct loan, so that the cost of buying foreign exchange may be reduced.

By the use of NDFs, customers could, according to hedging preference, buy or sell foreign currency without physical delivery of a notional amount and with the involvement of cash only for settling the gain or loss at the settlement date by taking the difference between the agreed upon forward exchange rate and the fixing spot rate at the maturity date. Actually,it makes no difference whether the notional amount is delivered since the borrower has to purchase forex for repayment. One of the most important features of NDFs is they allow an enterprise to sign an NDF contract with a bank and purchase forex at the spot rate at a different bank. This allows the borrower to choose any bank it likes to buy forex forwards (without delivery), so that it is able to choose the best forward price in the forex market.

Specifically, each bank’s guarantee fee, forex forward rate, and the interest rate of its agent overseas lending bank is different from those of others . As such, the optimal path for the borrower is to minimize all three costs. However, in most cases,the borrower buys forex forwards from the guarantor bank. It is very difficult to minimize all three costs in one bank, since the borrower can only obtain a credit facility from a limited number of banks. Fortunately, an NDF provides a solution: Step one,the borrower chooses a bank with the lowest guarantee fees and interest rate of its overseas agent lending bank. Step two, after receiving the loan, the borrower signs an NDF contract with another bank with the lowest forex forwards rate. Step three,at maturity date, the borrower honors the NDF contract and receives a bonus or penalty. Step four, to repay the loan, the borrower purchases the foreign currency at the spot rate at the guarantor bank and uses the bonus or penalty from the NDF to compensate for the spot forex rate.

In short, by giving the borrower more freedom and convenience, an NDF may indirectly but significantly reduce the foreign currency purchase cost and total cost of a cross-border direct loan.

Forex Options

The purpose of forex forwards is to fix the purchase price of the needed foreign currency. Of course, there are pros and cons to locking in all costs.The borrowers can avoid the risk of loss from forex apreciation, but loses the possibility of cost reduction from forex depreciation. To resolve this dilemma, a forex option may be a better tool for forex cost management.Forex options can control the effects of a sharp move in forex rates as well as reduce forex purchasing costs. In other words, by the use of a forex option, a borrower can find a balance between cost and risks according to its risk preference and expectations for the forex market.

Forex options refer to the transaction right between bank and client. After paying a certain amount of premium, the buyer has a right to exchange a particular currency at the agreed rate on a predetermined settlement date in the future. In the meantime, the seller of the option is obliged to exercise the transaction if the buyer chooses that.The client may be a buyer or seller of options. Additionally, when the forex option is combined with other forex derivatives, the borrower can enjoy benefits from various types of risk-cost combination products.Typically, the borrower may sign one of the following combination product contracts with the guarantor bank:

Buying call options: The borrower pays an option premium in order to gain the right to buy foreign currency at an agreed rate at maturity. If the forex spot rate is higher than the agreed rate at maturity, the borrower is able to exercise the option to lock in the forex purchasing cost as the agreed rate plus the option premium.That way, the borrower is able to control the forex risk. If the forex spot rate is lower than the agreed rate at maturity, the borrower does not exercise the option and instead buys foreign currency at the spot forex rate. Thanks to the call option,the borrower can partially enjoy the benefits of a reduced forex spot rate.The borrower must bear the cost of the option premium, but at least this provides a chance to reduce the purchasing cost of the forex as compared to forex forwards.

Purchasing forex forwards combined with selling a call option where the strike price of the option is higher than the agreed price of forex forwards: If the spot forex rate is lower than the strike price of the option at maturity, the option may not be exercised by the guarantor bank, and thus the borrower earns the option premium and buys foreign currency at the forward rate. Thanks to compensation from the option premium, the product significantly reduces the total forex purchasing cost compared to forex forwards. If the spot forex rate is higher than the strike price of the option at maturity, the option shall be exercised by the guarantor bank.The borrower first buys the forex at the forward rate from the guarantor bank. The borrower then sells the forex to the guarantor bank at the strike price to exercise the option.Finally, the borrower buys forex from the guarantor bank at the spot rate. Without locking in the upper limit of the forex rate, although the borrower suffers higher costs due to forex appreciation, it also can enjoy the compensation from the option premium and additional bonus equivalent to a balance between the strike price of the option and the rate on the forwards contract.The advantages of this combination product are, first, it lowers the cost of forex forwards by the option premium. Second, even the spot rate is higher than the strike price of the option, the cost is partly under control since it is compensated by the option premium and the bonus from the forex transaction. By contrast, the big disadvantage of this combination product is that a significant loss may not be avoided if the foreign currency appreciates sharply. This risk may be better managed through the combination of a reasonable premium and option strike price.

Selling a put option with a lower strike price combined with buying a call option with a higher strike price,which is named as “Risk Reversal Option” since a client may control the price within the two strike rates.Another feature of Risk Reversal Options is that since the two reverse options are done with the guarantor bank, the premium of both options are offset, which means the borrower enjoys this product “for free.” If at maturity, the forex spot rate is within the two strike rates, neither option will be exercised and the borrower buys the forex at the spot rate, which,of course, is within the expected region of the rate covered by the two strike prices. If at maturity, the forex spot rate is lower than the strike price of the put option, the put option will be exercised by the guarantor bank,which means the borrower buys the forex from the guarantor bank at the strike price and is unable to enjoy the lower spot forex rate. By contrast, if at maturity, the spot rate is higher than the strike price of the call option, the borrower will exercise the call option and lock in the forex rate at the strike price, so that it may avoid the extra cost from any sharp increases in the spot forex rate. The key attraction of the Risk Reversal Option is to lock in the forex rate within a specific region,instead of an exact specific value,without any additional fees. This helps the borrower balance the benefit from forex depreciation and the risk of forex appreciation, resulting in better overall cost control compared to forex forwards.

In conclusion, the borrower in a cross-border direct loan may use forex options to buy forex for repayment of loan principal and interest in order to better control the risk-cost balance, and reduce the total cost of the loan.

The introduction of forex derivatives represents a great improvement in CBDL. Of course,the use of derivatives also depends on many factors, such as the borrower’s preference, market circumstances,bank service strategies, and national regulations, etc. Considering these factors, the guarantor bank, when designing the comprehensive crossborder direct loan arrangement for its clients, may take into account one or all of the above-mentioned derivative products, to further enhance CBDL.Meanwhile, a borrower, when using cross-border direct loans, may take more consideration of forex derivatives tools, to further reduce its financing costs.