Carry Trades by Nonfinancial Firms

Many nonfinancial firms receive revenues in multiple currencies, and control assets in multiple countries.  Foreign exchange risk is thus present on these firms’ income statements and also on their balance sheets, both through the income effects and because the balance sheets of foreign subsidiaries must be translated to the parent company’s home currency in the consolidated balance sheet.

If an arbitrageur observes that risk-free rates in the Euro Area are lower than in the U.S. and wants to engage in a one-year carry trade, he borrows 1€ with maturity of one year, exchanges it into dollars at the spot rate s, which is the value of the Euro in dollars, and contracts to purchase enough Euros to repay his debt in the future, which costs f*(1+rfeur).  He then invests the proceeds at the risk-free U.S. rate for one year by purchasing a Treasury note or a CD.  At the end of one year, he receives s*(1+rfusd) and pays f*(1+rfeur) to settle his futures position. Covered interest parity holds when there is no arbitrage opportunity, or where

f/s = (1+rfusd) / (1+rfeur)

For a corporation that already is exposed to Euro revenues and assets and is trying to decide how to hedge, the choice is between hedging in the forward market and hedging by borrowing:

f/s   versus   (1+r*) / (1+rfeur+spreadeur)

  1. If the firm has no borrowing constraints in the U.S., the only benefit of having the cash translated from the Euro borrowing proceeds is that firm can borrow less in dollars and still maintain its target leverage. In this case, r* = 1+rfusd+spreadusd
      1. If rfeur<rfusd, then adding the spreads lowers the ratio and makes it preferable to hedge using forward contracts, UNLESS the EUR spread is much lower than the USD spread. This can happen in segmented markets, as in Gordon Liao (2017).
      2. If rfeur>rfusd, then adding the spreads raises the ratio and makes it preferable to hedge using debt, UNLESS the EUR spread is much higher than the USD spread.
  2. If the firm is unable to borrow in the U.S., then r* is the rate on the marginal investment, which would not have occurred without the Euro borrowing.
  3. A firm with existing Euro exposure through its revenues and/or assets has another advantage over pure arbitrageurs in that it can avoid some transactions costs.  An arbitrageur has to pay transactions costs both on (1) borrowing and exchanging at the spot rate, and (2) the forward contract.  The firm in this example has to pay transaction costs for (1) or (2), but not both.

Finally, there are reasons why firms might borrow in another currency even if no arbitrage is possible.

  1. Firms might be willing to take on foreign exchange risk in order to access lower borrowing costs.  This is most likely to be true for financially constrained firms.  If the size of the loan (controlling for the firm’s capacity to repay) is correlated with the risk of the loan and if the risk of the loan is correlated with the interest rate charged, then firms can access more capital by borrowing in currencies where the funding costs are lower.
  2. The firm has operational hedges by which it benefits from changes in exchange rates.  For example, a U.S. exporter that competes with European firms in world markets will see higher sales growth if the Euro strengthens.  This at least partially offsets the losses that would occur if the firm borrowed Euros and did not cover its position either with derivatives or with expected future Euro revenues.

Predictions:

  1. When rfeur<rfusd, lower-rated firms are less responsive to changes in interest rates, and higher-rated firms are responsive only if the EUR spread is much lower than the USD spread
  2. When rfeur>rfusd, lower-rated firms are more responsive to changes in interest rates, and higher-rated firms are responsive unless the EUR spread is much higher than the USD spread
  3. Larger firms are more responsive to changes in interest rates, if the cost of hedging using forwards is a convex function of the contract size
  4. Firms with tight financial constraints and good investment opportunities, such as young and small firms with high Tobin’s Q, or firms with high Q and lots of short-term debt, are more responsive to changes in rates.
  5. Firms that compete in world markets are more willing to borrow in the currencies of its competitors, and so are more sensitive to rate changes in those currencies.