1.

Introduction
1.1 Brief
In August 2002, the French retail giant Carrefour S.A. was considering alternative

currencies for raising (euro) EUR750 million in the Eurobond market. Its investment banks,

Morgan Stanley and UBS Warburg, had suggested that Carrefour to consider borrowing in

British pound sterling in order to take advantage of a borrowing opportunity in the currency in

Carrefour attempt of fund it expansion. This report was commissioned by a junior financial

analyst Sikhumbuzo Bhengu in request by Carrefour S.A.'s CFO Barry Strydom. The report was

requested in order to identify the cost effective currency in which the firm should issue the bond

to that currency denominated, and it f turn that foreign currency is effective then the hedging

strategy required to hedge exchange rate risk. The report required to be completed and handed in

on the 3rd of October 2011.

1.2 Method of investigation

This problem solving report is performed on the basis of the information in hand and the

report was not been expanded beyond the scope of the data information provided by Carrefour

S.A. There is no internet research conducted on the Carrefour S.A. position in the market. It is

assumed that the information provided in the case study regarding Carrefour S.A. is true and

accurate. The interest rate parity is the main underlying theory that is used in this report. The

excel spread sheet is only used and there is no other complex program used.

1.3 Problem definition

In the summer of 2002, Carrefour S.A. is seeking to raise €750 million debt financing at a

low costs by issuing it bond either in domestic country's (France) currency or issue foreign

currency denominated bond in the Eurobond market. In August 2002, Carrefour S.A.'s

investment banks (Morgan Stanley and UBS Warburg) had expected that the Carrefour 10-year

bonds can be issued at 5.25% in Euros, 5.375% in British pounds, 3.625% in Swiss francs, and
5.5% in U.S. dollars. It is assumed that these bonds are issued at par. Its investment banks also

suggested that the British-pound issue appears to provide the lowest cost of funds.

1.4 Objective
To examine the borrowing option which provide Carrefour with the lowest cost of funds.
To determine the currency risk hedging strategy
2. Data and Methodology
All the necessary data was given by Carrefour S.A. and excel was used compute all

needed bond payments including the repayment of principal. Excel was also used to compute the

forecasted exchange rate.

The exchange rate was forecasted using a market based forecast which is a forecast based

on market indicators such as forward rates. The forecasted exchange rate was computed using

the following formula (Kim and Kim, 2006: 207):

e_t=e_0 [〖(1+i_d)〗^t⁄(〖(1+i_f)〗^t])
Where e_t (forecasted exchange rate) is the euro price of one unit of foreign currency in

period t, e_0 (spot exchange rate) is the euro price of one foreign currency in the current period,

id is the domestic interest rate, and if is the foreign interest rate. The spot exchange rate and

interest rate was provided in the information given by Carrefour.

3. Findings
Carrefour S.A. to raise it debt should consider whether raising debt internationally is

cheaper than raise the debt domestically. The first step is to consider before issuing the foreign

currency denominated bond is examine the currency which offer lower yield on the bond, this is

crucial because the firm seek to find the cheapest bond payments. The foreign currency

denominated bond is exposed to exchange rate during the financing period hence there is no

guarantee that the foreign currency denominated bond will be cheaper than the domestic

currency denominated bond (Madura, 2008: 501). The different exchange rate for different
countries can cause the company to do not choose the foreign currency denominated bond with

low yield. The foreign currency denominated bond that seems to be superior (one with cheaper

coupon payments) to Carrefour S.A. then the firm will make coupon payments in that foreign

currency denominated bond.

It is essential to convert the €750 000 000.00 (domestic currency denominated bond) into

foreign currency denominated bond using current spot exchange rate, so that these principals will

be used to compute coupon payments needed to be paid by Carrefour. Table 1 below shows the

bond principal amount denominated in each country's currency and all other bond specifications.

Table 1: Bond specifications if issued in each of the four different countries.

France (€) UK (£) Switzerland (SF) US ($)
Principal 750 000 000.00 470 809 792.84 1 090 116 279.07 735 294
117.65
Coupon rate (%) 5.25 5.375 3.625 5.5
Maturity period 10 10 10 10
spot exchange rate 1 1.593 0.688 1.02

The table 2 below shows the coupon payments for the €750 million bond if it was issued

in France (domestic country) or if it is issued in foreign denominated currencies (pound sterling,

Swiss franc, and U.S. dollar). It is not easy to identify the currency which has the lowest cost of

bond because the bond payments are denominated in different currencies.

Table 2: The coupon bond payments denominated in each country's currency

Bond Cash outflows
Year End Euro Bond UK Bond SF Bond US Bond
1 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
2 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
3 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
4 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
5 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
6 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
7 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
8 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
9 39 375 000.00 25 306 026.37 39 516 715.12 40 441 176.47
10 789 375 000.00 496 115 819.21 1 129 632 994.19 775 735 294.12

The table 3 below shows the forecasted exchange rate for each year until the bond

maturity date. The decrease of the forecasted exchange rate for €/£ in the table 3 implies that the

Euro is expected to appreciate against the pound sterling throughout the ten years bond period.

This means that the coupon bond payments will be cheaper if the bond issued in Britain. The

€/SF values is increasing and this indicates that Euro is expected to be depreciating against the

Swiss franc over the bond period. This implies that the coupon payments for the Swiss franc

denominated bond will be costly over the years as Switzerland currency is expected to

strengthen. The €/$ exchange rate is a bit volatile than other exchange rates because for the first

six years the euro is depreciating against the U.S dollar and then appreciate for the last four

years. The U.S dollar denominated bond seems to be detrimental to Carrefour for the first six

tears and become beneficial for the last four years as euro strengthens against the dollar. The

overall outlook of the forecasted exchange rate seems to favour pound sterling denominated

bond compared to Swiss franc and US dollar denominated bonds.

Table 3: The forecasted exchange rate for Euro against pound sterling, Swiss franc, and U.S.
dollars
Forecasted Exchange Rate
Year End €/£ €/SF €/$
0 1.593 0.688 1.020
1 1.582 0.704 1.034
2 1.569 0.719 1.045
3 1.557 0.732 1.052
4 1.546 0.746 1.056
5 1.537 0.759 1.058
6 1.529 0.771 1.059
7 1.522 0.784 1.058
8 1.516 0.797 1.057
9 1.511 0.809 1.054
10 1.507 0.822 1.051
 The figure 1 below shows the exchange rate trend of euro against each foreign currency.

The Euro/pound exchange rate line shows a slowly declining trend over the years. While

Euro/Swiss franc and that of Euro/US dollar lines shows an upward trend over the years. This

clearly indicates that pound is better than Swiss franc and U.S. dollar.

Figure 1: The forecasted exchange rate for euro against different currencies

The table 4 below shows the coupon payments for the bond issued in each country's

foreign currency including France. The three other denominated currencies coupon bonds are

converted into Euro currency using current spot exchange rate under the assumption that the

exchange rate will remains the same throughout the whole bond period. The total coupon bond

payments including the principle that should be paid at the end of the bond maturity date, pound

denominated bond seems to be lower than Swiss franc denominated bond and that of US dollar

denominated bond, but higher than that of Euro denominated bond.

The annual cost of financing in the table 4 is also shows that Switzerland is superior to

France, UK and U.S. in terms of bond annual cost of financing. This is due to low coupon rate of

Switzerland bonds compared to other countries coupon rate bonds. If it is assumed that the

exchange rate will remain constant throughout the bond period, the Euro denominated bond has

lower costs than the foreign denominated currencies. This means it will be better for Carrefour

S.A to issue the bond denominated in Swiss franc but it is unrealistic to assume that the exchange

rate will remain the same because in real world the exchange rates fluctuate.

Table 4: Coupon bond Payments denominated in other currencies converted using spot exchange
rate into Euro currency
Spot exchange rate Conversion to Euro
Year End Euro Bond UK Bond SF Bond US Bond
1 39375000 40312500 27187500 41250000
2 39375000 40312500 27187500 41250000
3 39375000 40312500 27187500 41250000
4 39375000 40312500 27187500 41250000
5 39375000 40312500 27187500 41250000
6 39375000 40312500 27187500 41250000
7 39375000 40312500 27187500 41250000
8 39375000 40312500 27187500 41250000
9 39375000 40312500 27187500 41250000
10 789 375 000 790 312 500 777 187 500.00 791 250 000.00
Total 1143 750 000 1153 125 000 1021 875 000 1162 500 000
Annual CoF (%) 5.25 5.375 3.625 5.5

The Table 5 below is a more realistic scenario because the foreign denominated

currencies coupon payments and the end of tenth year principle are converted using fluctuating

forecasted exchange rate into Euro denominated currency. The lowest annual cost of financing in

table 5 is pound sterling denominated bond which is not only lower than other foreign

denominated bond but even lower than the domestic currency denominated bond. This shows

that issuing bond denominated in pound sterling cost less than issuing the bond domestically.

This is consistent with Carrefour S.A. investments banks suggestion that borrowing in pound

sterling the firm can take advantage of a borrowing opportunity in the currency.

Table 5: Coupon bond Payments denominated in other currencies converted forecasted exchange
rate into Euro currency
Convert using Forecasted Exchange Rate
Year End Euro Bond UK Bond SF Bond US Bond
1 39 375 000.00 40 024 747.73 27 829 700.49 41 821 892.02
2 39 375 000.00 39 716 284.73 28 405 049.43 42 248 587.89
3 39 375 000.00 39 413 348.58 28 943 668.96 42 525 488.66
4 39 375 000.00 39 133 672.06 29 464 498.28 42 697 232.02
5 39 375 000.00 38 887 836.37 29 976 799.15 42 787 818.35
6 39 375 000.00 38 680 592.91 30 483 398.92 42 816 283.96
7 39 375 000.00 38 506 609.19 30 985 433.50 42 793 910.96
8 39 375 000.00 38 359 427.82 31 483 817.35 42 731 805.75
9 39 375 000.00 38 234 983.52 31 977 811.67 42 631 454.99
10 789 375 000.00 747 544 052.68 928 147 191.10 815 217 530.32
Total 1 143 750 000.00 1 098 501 555.59 1 197 697 368.86 1 198 272 004.94
Annual CoF (%) 5.25 4.65 5.97 5.98

Figure 2 below is the above annual cost of financing in the graphical diagram. The pound

sterling denominated bond has the lowest annual financing cost followed by euro denominated

bond. The Swiss franc denominated bond has the highest annual cost of financing even though

this bond has the lowest coupon bond compared to other currencies.

Figure 2: The annual cost of financing in each country's currency denominated bond

Even though the pound sterling denominated coupon bond payments seems to be low

than domestic costs but since this only the estimated figures, the actual figures might be higher

than that of Euro denominated bond because of exchange rate fluctuations. The estimate forecast

does not account for uncertainty surrounding the forecast, in which it changes due to the

volatility of the currency (Madura, 2008: 506). Due to the uncertainty regarding the actual future

exchange rate hence it is essential that Carrefour S.A. hedge their position against exchange rate

exposure. For instance if Carrefour S.A. do not hedge it position, then if pound sterling

appreciate against the euro then Carrefour S.A. will be required to pay more funds to make the

coupon payments.

4. Alternative Solutions
4.1 Exchange rate risk hedging strategies
There are many strategies that can be used to hedge against exchange rate risk such as

foreign currency options, currency futures contracts, currency forward contracts, currency swaps,
parallel loans, and diversifying among currencies. The first two instruments (foreign currency

options and futures contracts) will not be applicable in this case because these instruments only

apply for short term period. These other problem of using these instruments is the high costs

associated with setting position on these instruments. For instance in using futures contracts the

user have to continually mark to market in order to sustain your position in the futures contracts.

If the investor chooses foreign currency options had to pay upfront the purchasing price of the

option known as premium which is irrecoverable if the investor chooses not to exercise the

option. The other problem of currency futures and options is that are inflexible and available

only for selected currencies (Kim and Kim, 2006: 178).

There are four strategies that are applicable for hedging exchange rate risk in this case

which is foreign currency forward contracts, currency swaps, parallel loans, and diversifying

among currencies because all these techniques can also accommodate the request of long term

horizon.

4.1.1 Foreign currency forward contract

A foreign currency forward contract can be used by Carrefour S.A. to lock in the

exchange rate for each payment. The foreign currency forward contract is traded over the counter

and no cash change hand at the date in which the parties enter the contract. Carrefour S.A. could

arrange to long the foreign currency forward at the end of each year in which coupon payment is

required to hedge against a rise in exchange rate. The problem associated with this approach is

that the forward rate for each period is most likely to be above the spot rate (Madura, 2008: 508).

This could cause hedging these future coupon payments to be more costly than the required

coupon payments if the Carrefour S.A. had issued euro denominated bond.

4.1.2 Currency swaps

The currency swaps can also be used by Carrefour S.A. to hedge against exchange rate
risk. ''A currency swap is a swap in which one party offers a certain principal in one currency to

its counterparty in exchange for an equivalent amount in different currency'' (Kim and Kim,

2006: 185). A currency swap involves three set of cash flows. First, the swap initiation, where

the two parties actually exchange the principals denominated in domestic currencies. Second, the

coupon payments in one currency are exchanged on regular dates for coupon payments in

another currency during the life of swap agreement (Chisholm, 2004: 55). Third, at the

termination of the currency swap agreement, the parties exchange the currencies in which the

principals are denominated (Kim and Kim, 2006: 185). The benefit of using currency swaps is to

provide protection against future exchange rates fluctuations, and firms can also use swaps to

reduce financing costs.

In this case the fixed interest rate will be used and it is assumed that the fixed interest rate

used in this currency swap is the coupon rate for euro denominated bond and the coupon rate of

pound sterling denominated bond. It is assumed that Barclays has good credit rating in UK but

wish to expand (open other branches) to France in which it is unknown to investors. The

Carrefour S.A. on the other side wants to borrower in UK where it can borrow at a low bond

yield. Both these firms are exposed to exchange rate risk and by entering cross-currency interest

rate swaps these firms will hedge against exchange rate risk. Carrefour S.A. will issue the euro

denominated bond in France (it domestic country) on behalf of Barclay, and Barclay will also do

the same for Carrefour S.A. in return by borrowing the pound sterling denominated bond on

behalf of Carrefour S.A. in UK.

4.1.3 Parallel loans

A parallel loan can be used by the firm to obtain financing in foreign currency. A parallel

loan occurs when two parties in different countries normally MNCs promise to re-exchange the
currencies at a predetermined exchange rate on a specified future date (Kim and Kim, 2006:

179). The parallel loans can be arranged without using the foreign exchange market. Parallel loan

agreements involve the same loan maturity and the same loan amount. Each MNC by using

parallel loan gain access in the foreign country's capital markets without any actual border flows

of capital.

A parallel loan is attractive if the MNC is undertaking a project or has a subsidiary in a

foreign country, and will receive cash flows from the project in the foreign currency. Each firm

borrow in its domestic market and lend to the other firm in foreign country in which it use the

money to finance it project in that foreign country, the other firm do the same in domestic

market. The loan is repaid on the foreign currency using project cash flows. By entering parallel

loan the MNC avoid foreign exchange risk because each loan is made and repaid in one currency

(Kim and Kim, 2006: 180). There are problems which limits the usefulness of this financing

strategy. A parallel loan is effective if each MNC should have a subsidiary or plan to undertake a

project in other country so that a loan will be repaid by subsidiary's currency. Second, one party

is obliged to comply with the terms of the agreement even if the other party fails to comply.

4.1.4 Diversifying among currencies

A firm may choose not to denominate its bonds by using only one currency rather

denominate it bonds in several foreign currencies so that appreciation of one currency will be

offset by depreciation in other currency (Madura, 2008: 514). This will keep the number of

foreign currency required from the firm to cover the financing payments. If the exchange rates of

two foreign currencies move in opposite direction against domestic currency. It is unlikely that

both foreign currencies denominated bonds could be simultaneously be more costly than the

domestic currency denominated bonds. Hence, financing with both types of bonds would almost

ensure that the firm's overall financing cost would be less than the cost from issuing domestic
denominated bonds. The problem with this strategy is that there is no guarantee the foreign

exchange rate will move in opposite direction against the domestic currency (Madura, 2008:

514).

5. Recommendation
5.1 Choice of currency denominated bond
The pound sterling denominated bond which is €470 809 792.84 when converted into

Euros has lowest cost of financing than both the domestic currency denominated bond and other

foreign currencies denominated bonds. The annual cost of financing of bond issued in UK is

4.65% and the total debt repayment is €1 098 501 555.59. These figures are lowest relative to

other bonds if issued in other countries bond markets as well if issued in domestic bond market.

The bond issued in UK is better even though has high nominal coupon rate than that of

Switzerland and the lack of any material business activity conducted by Carrefour S.A. in UK.

This is consistence with the suggestion of Carrefour S.A.'s investment banks that the firm should

raise it required debt financing (€750 000 000) in UK because British pound denominated bond

appear to offer the lowest cost of financing.

5.2 Best Hedging Strategy

Carrefour S.A. since the lowest cost bond is that has to be issued in UK. The problem

since this bond is foreign issued bond is that the firm needed coupon payments will be exposed

to exchange rate fluctuations. Carrefour S.A. to hedge its 10-years pound denominated bond

issue against exchange rate risk has to choose among the currency hedging strategies discussed

above.

The currency swap strategy seems to be a superior hedging strategy than other strategies

because this strategy does not have drawback which are found in other hedging strategies.

Currency swaps will enable Carrefour S.A. to completely eliminate exchange rate risk without

bearing additional costs.

 The other strategies cannot be used by Carrefour because of the drawbacks in these

strategies. The foreign currency forward contract could be effective if Carrefour S.A. would have

to pay one nominal value at the end of bond maturity. Due to streams of cash outflows foreign

currency forward contract could make the financing cost of UK choice to be costly than

domestic bond issue because exchange rate fluctuations could cause forward rate to be above

spot rate, hence currency forward contract could not be used. A parallel loan is not applicable

because Carrefour does not have operation in UK and this means the interest payments should

cross borders. Carrefour S.A. would be exposed to exchange rate due to lack of subsidiary or a

project in UK. A parallel loan has other drawbacks which cause it less attractive and these

limitations can be overcome by using swaps. For instance, if one party default on its obligations

the other party is not legally relieved from the defaulting party (Kim and Kim, 2006: 180). This

is because parallel loan is actual two loans with separate agreement existing independently of

each other. With currency swaps the right of offset is usually embodied in the swap agreement.

It is recommended that Carrefour to adopt currency swap strategy to hedge it position

against exchange rate exposure. This will enable Carrefour to exploit low financing costs to its

fullest potential. This will enable Carrefour to be able to expand as CEO anticipated but a

reasonable cost of financing and this will enhance the net profit of the firm. The figure 3 below

illustrates the currency swap transaction that will take place if Carrefour S.A. adopts currency

swap strategy. In panel A. shows that Carrefour S.A. issues euro denominated bond in France

then take these Euros and passes them to Barclay, which in return gives Carrefour S.A. the £470

809 792.8 it needs. On the interest payment dates which is the end of the year, the swap

generates €39 375 000 which is exactly the amount Carrefour S.A. needs to settle the coupon

payments to its bondholders (Panel B). Carrefour S.A. in turn makes the coupon payments in
pound sterling. The coupon payments will occur until the end of ten years. At the end of the

transaction (end tenth year), Carrefour S.A. receives €750 000 000 back from Barclay and

transfers it through to its bondholders (Panel C). Carrefour S.A. in turn pays £470 809 792.8 to

Barclay, thus effectively paying off a pound denominated bond.

Figure 3: The currency swaps transactions

Panel A: Initial cash flow

Panel B: Annual coupon payments

Panel C: Repayment of Principle

6. Conclusion
Carrefour S.A. should raise their required debt financing of €750 000 000 to ensure it

expansion, by issuing the bond in UK because pound denominated bond has lowest cost of

financing than other currency denominated bonds. The problem is that a pound denominated

bond is offered in foreign currency so it is exposed to exchange rate fluctuations. It is important

that Carrefour hedge against exchange rate risk using currency swaps in order to exploit the

benefit of issuing pound denominated bond. This will enable Carrefour to limit it costs by issuing

low cost bond and this will help the company to meet its goals of increasing it net profit by 10 to

15 percent.

7. Bibliography
Chisholm, A.M. (2004) Derivatives Demystified: A step-by-step guide to forwards, futures,
swaps and options. John Wiley & Sons, San Francisco.
Kim, S.H. and Kim, S.H. (2006) Global corporate finance. Blackwell Publishing, Oxford.
Madura, J. (2008) International Financial Management, Thomson, United States.