I\’ve long believed that exchange rates can be the single toughest subject to teach to introductory economics students. Talking about travelling abroad and exchanging currency can help understand how someone can benefit or lose from movements in exchange rates. But when trying to explain exchange-rate risk for nations or private firms who have borrowed in one currency and need to repay in a different currency, more practical examples are a big help, too. Adam T. Jones,William H. Sackley and Ethan D. Watson have a very nice example all worked out and ready to be plugged into your reading list or lecture notes. It appears as \”Teaching exchange rate risk using London\’s Gherkin building: How investors were in (and out of) a pickle,\” in the Journal of Economic Education (2017, 48:4, 276-287). (The JEE is not freely available online, but many readers will have access through a library subscription.)
Here\’s a picture of the Gherkin.
\”Unfortunately, the structure of the deal eventually led to financial implosion. There were two important aspects to the structure of the deal. First,GBP 396 million of the GBP 600 million purchase price was financed with debt, and the rest was equity investment from the IVG Euro Select 14 Fund and Evans Randall’s equity investment. The GBP 396 million loan was denominated in two currencies: GBP 212 million worth was borrowed in British pounds, and GBP 184 million worth (CHF 447 million) was borrowed in Swiss francs. Second, the deal structure also included a loan-to-value clause, which required the group to not exceed a 67 percent loan-to-value ratio. …
\”[I]n reality the financing of the building in two currencies was reasonable, because the lease paymentswere being collected in pounds sterling and Swiss francs. Swiss Re occupied approximately half the building and paid their rent in francs. The other tenants were British firms paying rent in pounds sterling. Therefore, the lease payments were providing a partial hedge of the foreign exchange risk for interest payments but not the principal value of the loan. Thus, despite some rent being paid in francs, IVG was exposed to a less than fully hedged, foreign exchange risk.
\”At the time the deal was struck, the CHF per GBP exchange rate was approximately 2.4 Swiss francs per British pound.After the deal was struck, the value of the pound relative to the franc dropped (franc’s value appreciated) significantly from late 2007 until late 2011. In the end, the franc appreciated over 60 percent causing the value of the debt to increase by approximately GBP 100 million. … [T]he increased loan value triggered the 67 percent loan-to-value (LTV) limit clause in the financing because the new ratio would have exceeded 79 percent under the new exchange rate.
\”As a result of the increased LTV ratio exceeding the contractual limit, the consortium of financing banks, led by BayernLB, demanded more collateral and blocked the flow of rental income. Thus, in a twist of irony, the owners of a building leased to a firm that mitigates risk were unable to navigate the risks of a complicated financial structure and defaulted on their debt. The Gherkin building was placed into receivership in 2013, and was sold in foreclosure to Brazil’s Safra Group for GBP 726 million in 2014 …\”
Jones, Sackley and Watson offer a detailed description of how to walk through this example in a classroom setting. To me, the example is especially interesting because it\’s a vivid example of the subtle ways that exchange rate risk can arise. One of my standard examples of exchange rate risk involves working through what would happen to a bank in Thailand that borrowed in US dollars, but loaned in Thai baht. A sharp depreciation of the baht can then make it impossible to repay the US dollar loan, as in the east Asian financial crisis of 1998-99 (for discussion, see Ch. 31 of my principles of economics textbook). But apparently, the rent from the tenants of the Gherkin was enough to continue paying off the debts involved in its purchase. In this case, the foreign exchange risk instead arose from how the exchange rate movements affected the loan-to-value ratio in the contract.