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CASE STUDY

The practical application of credit derivatives with regards to interest rates and foreign

exchange rates and its monetary effects shall be pictured by project financing a hotel investment

project in the Hungarian capital of Budapest. The investing company is an Austrian Ltd., who is in the construction

field. They started operations in the year 1990. First investments were in the home country. They started to enter into

foreign markets in the beginning of 2000.

They have branches all over in the European Union. They also have an office in Budapest,

where 20 employees are working. Despite of the crisis of the industry the Hungarian branch

survived and generated profit in the last three years. The lesson they have learnt from the crises 2007-

2009 is that they should take into consideration the exchange rate risks. The managers of the Budapest office are

trying to implement some hedging instruments that can protect the investment. It is really hard to make the right

decision, and choose the best hedging tool.

After assuming several parameters a base scenario is calculated without the use of financial

derivatives. Thereafter, three different scenarios should be compared in order to illustrate the results and

deviations to the base case .

Furthermore make your own assumptions for the EUR/HUF exchange rate during 2012-2021 ,

and give reasons for your choice. After illustrating your prediction please compare it a banks

prediction on which should make your comments.

There are plans for building a four star hotel with 180 rooms which shall be operated by an

international hotel management brand.

A special purpose vehicle for developing and operating the project has been set up and

acquired a plot of land. Planning works which resulted in a valid building permit having in

place have been completed. The costs incurred so far have been covered by shareholder

loans by the sponsor.

Total acquisition and construction cost is budgeted at EUR 21.4 mln. For the realization

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of the project the sponsor decided to take out a bank loan. The shareholder negotiated a term

loan for a 10 years period and a debt/equity ratio of 70%. Thus, the loan granted by the bank

totals to EUR 15 mln. The remainder of 30% respectively EUR 6.4 mln as equity is needed to

be provided by the sponsor. It is required by the bank to spend equity first. As equity has

already been spent for acquisition, planning and depositing for interest expenses in the first

three years, the loan will entirely be used for construction which is estimated at two years.

Real estate finance is typically a long-term investment and takes usually between fifteen and thirty years to redeem the loan

completely. In the present case the project company faces a residual loan amount after 10 years which is subject to refinancing

by the sponsor under future market conditions . Therefore, the case study shall only focus on the development phase of 2

years as well as the subsequent investment phase of another 8 years.

Naturally, a real estate investment project faces various kinds of risks. There might occur

restitution claims with regards to a land, planning risk, market risk that is highly dependent on

overall economic situation and also affects construction costs as well as the operating risks

during the hotel operation are only a demonstrative numeration of the wide range of immanent risks.

The present case studies will exclusively focus on financial risks. As the loan is denominated in

EUR and expenses on construction as well as operating income after opening of the hotel is in

HUF, the company faces a steady foreign exchange risk. Moreover, interest payments upon

the bank loan refer to the underlying 3-Month-EURIBOR which fuels additional risk of

interest rate volatility to the cash flow of the project.

The loan of EUR 15 mln granted by the bank refers to the 3-Month-EURIBOR which is a

floating reference interest rate. The additional margin charged by the bank amounts to 2% p.a .

A fixed repayment schedule has been established (table 9). During the development phase and the first year of

operation no redemption of principal will be made. Principal repayments start in the second year of hotel operation.

Nevertheless, interest payments are to be made which will be covered by equity by the shareholders.

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table 2

http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-huf.en.html

Naturally, floating reference rates are subject to constant volatility as table 2 has illustrated above. It has been

assumed that the high liquidity in the markets due to the expansive monetary politics of the ECB will result in

increasing interest rates over the next years.

Case Study.

Principles and Practices of Finance; Beta Bartalos

http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-huf.en.htmlhttp://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-huf.en.html