Currency Risk When Loaning to a European Friend
July 21, 2018 11:18 AM Subscribe
I'm American and want to loan money to a European friend with a term circa 10 years. We're worried about currency issues; one of us could get zonked (that's the financial term) if our respective currencies diverge. We're obviously not unique in confronting this predicament. Are there any clever standard solutions to protect us both?
Exacerbating factor: to guard against inflation, I'd need us to adjust interest periodically (US Prime + X%), creating further potential for unexpected divergence (i.e. if Europe's inflation is lower).
Exacerbating factor: to guard against inflation, I'd need us to adjust interest periodically (US Prime + X%), creating further potential for unexpected divergence (i.e. if Europe's inflation is lower).
Response by poster: My concern is not just for my risk, but for his as well. As I said, he's a friend.
Protecting myself is easy. Making this work for both of us is hard. Hence my query.
posted by Quisp Lover at 11:31 AM on July 21, 2018
Protecting myself is easy. Making this work for both of us is hard. Hence my query.
posted by Quisp Lover at 11:31 AM on July 21, 2018
Best answer: This is called hedging, and financial and trading companies hardly make a contract without it. It's explained here better than I can explain.
But, for example, Suppose you lend the money in dollars. Your friend buys an option to buy the dollars need to repay the load at a particular price. If the value of the dollar falls, the option is worthless, but you friend can repay the load cheaper than if the dollar had held it's price. If the value of the dollar rises, he can exercise the option and buy the dollars at an advantageous price.
posted by SemiSalt at 11:43 AM on July 21, 2018 [2 favorites]
But, for example, Suppose you lend the money in dollars. Your friend buys an option to buy the dollars need to repay the load at a particular price. If the value of the dollar falls, the option is worthless, but you friend can repay the load cheaper than if the dollar had held it's price. If the value of the dollar rises, he can exercise the option and buy the dollars at an advantageous price.
posted by SemiSalt at 11:43 AM on July 21, 2018 [2 favorites]
Best answer: You may want to write up a currency future contract. As far as I know, that's the standard way to hedge against foreign exchange risk.
Here's a basic explanation from Wikipedia: A currency future, also known as an FX future or a foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar.
Basically, you set the exchange rate (or range of acceptable exchange rates) at the date of purchase, so that even if things go wildly awry, nobody gets screwed.
posted by rue72 at 11:43 AM on July 21, 2018
Here's a basic explanation from Wikipedia: A currency future, also known as an FX future or a foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar.
Basically, you set the exchange rate (or range of acceptable exchange rates) at the date of purchase, so that even if things go wildly awry, nobody gets screwed.
posted by rue72 at 11:43 AM on July 21, 2018
Best answer: You could also divide the loan amount in half, and loan half in US dollars and half in euros. That way if there is a big exchange difference, you would both get only half the impact.
posted by Short End Of A Wishbone at 12:09 PM on July 21, 2018 [11 favorites]
posted by Short End Of A Wishbone at 12:09 PM on July 21, 2018 [11 favorites]
Large institutions hedge currency risk, as SemiSalt said. They can either buy an option, forward, or future of various flavors, as mentioned, or they can engage in a currency swap with some other institution that is exposed in the opposite direction.
(By the way, OP can't just "write up" a currency future. They are traded directly on exchanges with clearinghouses. The counterparty would need to buy a future and then maintain a margin account with their broker for the ten years. Fairly awkward.)
The problem is that these mechanisms cost money, paid either directly to a counterparty or to an intermediary, and so are rarely suitable for small personal loans.
You can't really protect both parties to a loan. Your interests are inherently in conflict. You can opt to artificially constrain the exchange rate in the contract (there's nothing stopping you from putting in the contract that you will accept 1.5 Currency X for each USD even if the market rate is 2.0), but then that is laying some risk off on you. Your friend will have to decide if he can bear currency risk or not. If he can't, he should look locally for money.
posted by praemunire at 10:24 PM on July 21, 2018 [2 favorites]
(By the way, OP can't just "write up" a currency future. They are traded directly on exchanges with clearinghouses. The counterparty would need to buy a future and then maintain a margin account with their broker for the ten years. Fairly awkward.)
The problem is that these mechanisms cost money, paid either directly to a counterparty or to an intermediary, and so are rarely suitable for small personal loans.
You can't really protect both parties to a loan. Your interests are inherently in conflict. You can opt to artificially constrain the exchange rate in the contract (there's nothing stopping you from putting in the contract that you will accept 1.5 Currency X for each USD even if the market rate is 2.0), but then that is laying some risk off on you. Your friend will have to decide if he can bear currency risk or not. If he can't, he should look locally for money.
posted by praemunire at 10:24 PM on July 21, 2018 [2 favorites]
Unless you are talking a large sum and a single repayment there is a very good chance that any hedging instruments are going to work out more expensive over time than than occasional fluctuations. If you look at exchange rates over time they move up and down, sometimes there are fundamental changes in one economy, that cause a rate to settle at a different level for a while. But if you agree on regular repayments a lot of this would even out over time.
If you really want to go there I like the idea to specify in your loan agreement, that 50% of the loan is in your currency and the other 50% in theirs and that all repayments, irrespective of what currency they are, get applied to both parts of the loan equally until one is fully paid off and then the repayment is allocated to the other part fully. You can also apply different interest rates for each currency using appropriate central bank rate + bases. That would make it about as equitable in terms of risk as you can get without one or both of you buying derivatives.
posted by koahiatamadl at 5:15 AM on July 22, 2018
If you really want to go there I like the idea to specify in your loan agreement, that 50% of the loan is in your currency and the other 50% in theirs and that all repayments, irrespective of what currency they are, get applied to both parts of the loan equally until one is fully paid off and then the repayment is allocated to the other part fully. You can also apply different interest rates for each currency using appropriate central bank rate + bases. That would make it about as equitable in terms of risk as you can get without one or both of you buying derivatives.
posted by koahiatamadl at 5:15 AM on July 22, 2018
If you use the "split in half" method, isn't this the same as saying you are locking today's exchange rate?
posted by Mid at 7:19 AM on July 22, 2018
posted by Mid at 7:19 AM on July 22, 2018
Response by poster: Mid, I don't see that. Can you explain?
Problem with split in half is that we'd both be killed by recurring currency conversion cost overhead. And the other moves, while interesting, are overly complex. This likely can't be done efficiently.
posted by Quisp Lover at 9:25 AM on July 22, 2018
Problem with split in half is that we'd both be killed by recurring currency conversion cost overhead. And the other moves, while interesting, are overly complex. This likely can't be done efficiently.
posted by Quisp Lover at 9:25 AM on July 22, 2018
You can't magically make currency risk go away. You can only buy insurance for that risk and insurance is a deadweight cost.
Here is how you can self-insure. Let's say you loan 10,000 U.S. dollars to your friend and let's assume that the current exchange rate is 1:1 for simplicity. Your friend converts that 10,000 U.S. dollars into 10,000 euros and uses it as needed.
As insurance, you simultaneously take out a loan in Europe for 10,000 euros which you turn around and deposit into an interest paying European bank account.
10 years later, if the euro declines 10% against the dollar, you can pay off your euro loan with 9,000 U.S. dollars for a gain of 1000 dollars. Meanwhile your friend pays you off with 10,000 euros worth 9,000 U.S. dollars for a loss of $1000. The $1000 gain and
$1000 loss cancel each other.
If on the other hand the euro rises 10% against the dollar, you have to pay off your euro loan with 11,000 U.S. dollars for a loss of $1000. Meanwhile your friend pays you back with 10,000 euros worth 11,000 U.S. dollars for a gain of $1000. The $1000 gain and the $1000 loss cancel.
So is this a free lunch? No, because you have to pay interest on the 10,000 euros that you borrowed as insurance. The difference between the interest rate of borrowing 10,000 euros and depositing 10,000 euros in a bank account is the cost of your insurance.
Let's say that you can borrow euros for 4% and the bank pays 1% on deposits. The difference, the cost to you is 3% per year, or 300 euros. Over 10 years, that comes to 3000 euros. That's quite expensive insurance. It only pays off if the exchange rate changes substantially -- like 30% or more. And somewhat impractical since you will have difficulty borrowing and depositing in a foreign bank.
posted by JackFlash at 10:09 AM on July 22, 2018 [1 favorite]
Here is how you can self-insure. Let's say you loan 10,000 U.S. dollars to your friend and let's assume that the current exchange rate is 1:1 for simplicity. Your friend converts that 10,000 U.S. dollars into 10,000 euros and uses it as needed.
As insurance, you simultaneously take out a loan in Europe for 10,000 euros which you turn around and deposit into an interest paying European bank account.
10 years later, if the euro declines 10% against the dollar, you can pay off your euro loan with 9,000 U.S. dollars for a gain of 1000 dollars. Meanwhile your friend pays you off with 10,000 euros worth 9,000 U.S. dollars for a loss of $1000. The $1000 gain and
$1000 loss cancel each other.
If on the other hand the euro rises 10% against the dollar, you have to pay off your euro loan with 11,000 U.S. dollars for a loss of $1000. Meanwhile your friend pays you back with 10,000 euros worth 11,000 U.S. dollars for a gain of $1000. The $1000 gain and the $1000 loss cancel.
So is this a free lunch? No, because you have to pay interest on the 10,000 euros that you borrowed as insurance. The difference between the interest rate of borrowing 10,000 euros and depositing 10,000 euros in a bank account is the cost of your insurance.
Let's say that you can borrow euros for 4% and the bank pays 1% on deposits. The difference, the cost to you is 3% per year, or 300 euros. Over 10 years, that comes to 3000 euros. That's quite expensive insurance. It only pays off if the exchange rate changes substantially -- like 30% or more. And somewhat impractical since you will have difficulty borrowing and depositing in a foreign bank.
posted by JackFlash at 10:09 AM on July 22, 2018 [1 favorite]
I was thinking that any change to one half of the loan in terms of relative currency value is offset by the opposite change to the other half, but perhaps I am not tracking correctly.
posted by Mid at 10:52 AM on July 22, 2018
posted by Mid at 10:52 AM on July 22, 2018
Re splitting the load into two currencies - note that the exchange rate is just math. The borrower doesn't have to pay you in actual Euro and US Dollars each time -- they can just keep the accounting in both currencies but do the current exchange rate math to pay you in one currency. I'm no forex trader but I think that should work, right?
posted by troyer at 10:55 PM on July 22, 2018 [1 favorite]
posted by troyer at 10:55 PM on July 22, 2018 [1 favorite]
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posted by saucysault at 11:28 AM on July 21, 2018 [5 favorites]