Gaz De France Case Solution

2. Based on the data of your chosen economic indicator, what is its trend over the period 1980 to 1985 and how would you expect the French Franc to move against the dollar over these years? Will it appreciate or depreciate against the dollar?

As per the preliminary analysis, the current account balance is assumed to be the key parameter for determining Franc-Dollar exchange rate. The historical trend of the current account is depicted in the following graph:

From 1980 to 1982, the current account holds a decreasing trend in which the deficit is consistently increasing at a considerable rate. However, the results of the post-1982 policies are clearly evident in the form of a sudden increase in the account balance. Current account represents the differential of the trade balance, hence, an increase in the balance infers that the consumers demand more local currency for translation of their holdings. The linear line is also upward sloping. As per the trend, the demand for the Franc should increase in the future. The increased exports (as projected by the positive increase in the account balance) will require the foreign buyers to acquire local currency (Franc). As a result of the enhanced demand, French Franc should appreciate in its value, and the Dollar-Franc exchange rate should drop. At the end of 1980, the Franc/Dollar exchange rate is 4.22. This rate should decrease in order for the Franc to appreciate in its value.

3. Now look at Exhibit 6 and comment whether the actual French Franc Rate reflect the trend that your answer in 2. Above would have suggested.

The actual movement of the Franc over the period of given five years is depicted in the following graph:

As opposed to the forecasted movement, the exchange rate increased in such a manner that Dollar maintained a continuous appreciation relative to French Franc. Only after the start of 1985, the French Franc started to appreciate in its value. However, throughout the majority of the prescribed time frame, the French Franc sustained a steady depreciation. There could be various reasons for the discrepancy in the forecast and the actual outcome. Firstly, even though current account is one of the most crucial determinant of exchange rate, it still requires the input of the effects of other variables. The decrease in the interest rates coupled with the steady state of the foreign exchange reserves predicted that the French Franc will depreciate. In spite of the fact that current account balance hold the maximum importance, yet it was not able to counter the magnanimous downward push created by these two parameters.

4. Please explain the reasons what were the risks that Gaz de France was facing which forced it to enter into the swaps and forward transactions.

After the nationalization regime, Gaz De France was exposed to a handful of debt market participants. In this situation, the possibility of raising additional financing through debt issuance from the local market was largely restricted. Hence, GAz De France had to rely on foreign currency dominated bonds. It issued to bonds in a foreign currency. This applies that Gaz De France had to pay the interest payments in the same currency. Moreover, the tenure of the bonds was also long term. This scenario raised the risk of the unfavourable variation in the interest payments. By the end of 1981, the increasing trend of the Franc/dollar exchange rate was evident. In the case of more devaluation of Franc due to the Franc/Dollar appreciation, the interest payments needed to be large. Amid the uncertainty in the future exchange rate, the risk of the increased interest payment forced Gaz De France to engage in Swaps and forward contracts. These contracts will inflow a predetermined or fixed amount of Dollars to the company in exchange for a fixed prearranged Franc payment terms. Hence, the company will essentially limit the risk of variable interest payments by exchanging the French currency at a future date under the fixed terms.

5. Using you understanding of the Forward transactions, illustrate how Gaz de France could be using a forward contract to reduce some of the risks that you identified in 4 above.

The prime and foremost risk comprises of the variation in the payments of the interest (for the foreign-dominated Bonds). For this purpose, let’s assume that Gaz De France just issued five-year dollar dominated bonds with annual payments of 10% of face value (in 1981). Also, let’s assume that the face value of debt is $1 million. In the current scenario, Gaz De France has to pay $100,000 of annual interest. However, the current monetary base of GDF is in French Franc. Hence, in the absence of any swap or forward contract, GDF has to convert the Franc for a corresponding amount of payment at the market exchange rate (at the interest payment date). The exchange rate at the beginning of 1981 is 4.2205. Let’s assume two situations. In the first scenario, GDF does not enter into any forward contract. In the second one, GDF enters into a forward contract to convert FF450000 (of $100,000) at a rate of 4.5 (Franc/dollar) at the end of the year. Now, the end of the year exchange rate is 5.4086. In the first scenario, GDF has to translate FF540860 in order to meet the interest obligation of $100,000. In the second scenario, as per the contract, GDF has to pay only FF450, 000 for the corresponding conversion. Hypothetically, if the actual year end rate were below 4.5, then GDF could have gone directly to the market for conversion of Franc. The forward contracts do not constitute a legal obligation to complete the transaction, hence. GDF could have reduced the risk of high exchange rate by simply entering into the specific forward contract. A loss arising from the currency translation is minimized regardless of the year end actual exchange rate. GDF can enter into these contracts annually to minimize the risk of variable interest payments. The following table depicts the detailed calculations for both scenarios.