Credit Risk Spreads in Local and Foreign Currencies

Abstract

Governments, corporations, and even small firms raise and denominate capital in different currencies. We examine the micro‐level factors that should be considered by a borrower when structuring debt denominated in various currencies. This paper will show how the currency composition of debt affects the cost of debt through the interaction with the risk of company's assets. We look at the currency mismatch in the firm and analyze its credit spread within a Merton's type model with bankruptcy. We show that foreign currency borrowing is cheaper when the exchange rate is positively correlated with the return on the company's assets. The determining factor is not just whether a given company is an exporter or importer, but rather the statistical correlation between the rate of return on the firm's assets and changes in the exchange rate.

Macroeconomic Effects on Emerging-Markets Sovereign Credit Spreads

“…27 ∂B ∂ < 0. 28 This is, to our knowledge, the first empirical evidence in support of Galai and Wiener's (2012) argument that in a multicurrency environment, a company (country) wishing to minimize the probability of insolvency (and thus the costs of financing) should elect to finance activities in its own currency and, where this is financing should elect to finance activities in its own currency and, where this is not possible, in a currency that is highly correlated with the rate of return on the economy. Let S t denote the spot exchange rate at time t expressed as the price of 1 unit of local currency in USD and F T,t the forward exchange rate (the price of 1 unit of local currency in USD) at time T for delivery at time t. By definition B * t = S t B t and A * t = S t A t .…”

Macroeconomic effects on emerging-markets sovereign credit spreads

“…Multi-currency borrowing is another potential source of omitted variable bias. In a multicurrency environment, the probability of insolvency and the costs of financing depend on the correlation between the company's rate of return and the exchange rate with respect to the borrowed currency (see Galai and Wiener, 2012). This type of analysis has been applied empirically on corporations (e.g.…”

Measuring sovereign credit risk using a structural model approach

“…He also demonstrated a sovereign structural model driven by the sovereign's repayment capacity (includes international reserves exports and imports) and total amount of external debt in six emerging countries. Galai and Wiener (2012) showed that the government or company should issue the debt denominated in foreign currency since the funding cost is cheaper if the statistical correlation of asset return and changes in exchange rate is positive.…”