[SOUND] Let's talk about these alternatives and we're going to start with the previous example. In fact, that previous example has an almost trivial solution. Let me remind you what we're talking about. We're having this company that expects to borrow in 3 months. The current rate is 3%. And the company is concerned about the risk that interest rates will go up, right? What's the previous solution? You can issue the commercial paper today. Maybe you've thought about that already, right? Why is the professor talking about this, it seems like this is what the company should do is borrow today. You are right. That is in fact a good solution to this problem. What happens is, in this case, you'll pay 3%. No matter what happens to interest rates. But we're not done. What else does the company need to do if you are going to really hedge the interest rate risk? There is one more step. Here it is. The company needs to hold cash. That's why this lecture is about liquidity, okay? In order for these alternatives to work, the company's going to have to hold the cash, right, instead of spending it. because we have a financial planning model in the background that tells us we're going to need cash in three months. If you borrow today and spend it, you're going to need to borrow again. The hedging is gone, right? So that's why it's liquidity that is a substitute for hedging. You need to hold cash if you want to hedge in the right way. And, as we're going to see, that's going to be a general principle we're going to learn in this lecture. Okay, the company has to hold the cash. And, of course, that is going to introduce potential risks. You have to invest in a safe asset, right? Because you want to make sure you're going to have the money. So you shouldn't be buying risky equity, for example. The safe asset is likely to produce a low rate of return. You're going to pay a liquidity premium, right? The interest payment that you receive on your safe asset, it may be low but it's taxable, so there's going to be a tax deal, right, that you have to take into account. And finally, I don't want to take for granted that the company will keep the cash. Once you put the money in the company, the CEO may be tempted to spend the cash instead of hoarding it. So that may introduce problems as we already discussed it in this course, cash can burn a hole in the pockets so companies could be tempted to overspend. All right, we talked about this when we discussed the payout policy for example, right? Because of all of these problems, hedging with liquidity is also going to be imperfect. Let me give you another example. And this is a really cool one, I think. That's actually going to show you why I choose December 14 for the Russian example, okay? So, now we go back to our US company that needs to make that rouble payment, right? It's in December 15, so it's in one year. And remember that the company's concern is that the roubles may appreciate relative to the dollar, so the company is proposing to enter a forward contract at that amount that guarantees a payment of 3.4 whatever, right? In one year, you got the idea, we did this already. Let's think about a situation when the forward was not available, which is totally possible for smaller countries, right? If you have a payment that is due in a longer time period, or maybe, because of settlement risk you may not be able to buy a forward contract. So, what the company can do is to buy roubles in the stock market. You can buy the roubles today. The same idea as the interest rate example. Instead of buying roubles tomorrow, you can buy them today. That is also going to eliminate your exchange rate risk, as we're going to show next, right? If you look at the table that I gave you from the Financial Times, the current exchange rate is 55.667. That's the current rate at which you could buy roubles at December 2014. So now let me ask you this question. What does the US company need to do with the roubles? Think about that. It has to invest in a safe asset, but the asset has to be in roubles. If you have roubles and you changed them back into dollars, when that year comes you're going to have to buy roubles again, so it didn't work, right? In this case, the hedging position requires you to hold cash in roubles. I hope you got that answer. Let's develop that, how would that work? We have to think about what the interest rates were. So at that time, the 1-year interest rate on a Russian government bond was 16.8%, while the rate on a 1-year US T-bill was just 0.2%. T-bill rates has been very low in the US, as you probably know. So how many roubles does the company need to buy? That's what this equation is doing here for you. You need 200 roubles in one year, right? So if you invest at 16.8%, that means you're going to buy 171.244 million roubles, right? So you don't have to quite buy 200 because you can invest in roubles and you're going to earn the interest, right? So that's the amount, a simple discounting problem. So, that money turns into 200 million roubles in one year. Right, how much does that take to buy that today given the current exchange rate, which is here? That's going to take you 3.076 million dollars. So it's approximately 3 million dollars, right? If the company does this transaction, think about this, your hedged against exchange rate risk. You changed dollars into roubles today. You hold the roubles, right? In one year, you can use the roubles to make the payment. You're done. Again, liquidity substitutes for hedging, right? There are a few things here that you may be worried about. The first one is not a problem, all right? The amounts are different. So now we are spending 3.076 today instead of 3.082 tomorrow, as we were doing before with the forward contract, right? 3.082 is the amount you're spending if you're hedging the risk with the forward contract. Is this the same amount? The answer is yes, because if you had invested the the 3.076 today in a treasury bill, you would get exactly 3.082 tomorrow, okay? So, that's how I put the numbers actually. What I used here is the notion of interest rate parity. I actually assumed that the interest rates where such that interest rate parity exactly worked. Essentially what the interest rate parity means is that the relationship between the futures and the spot rate has to be the same as the relationship between the interest rates on two different currencies. All right, this is not really a topic of corporate finance, but I want to mention it here just to clarify this example, and the idea is that investors should be indifferent between investing in dollars or investing in roubles. If investors are perfectly indifferent, then interest rate parity should work. The problem is, of course, the real world is always more complicated than our example, right? The actual one year Russian government bond rate was not 16.8%. I made up that number, I was cheating, okay? The actual rate was 15.6 in December 14. So, in order to have 200 million roubles in one year, the US company would actually have to spend more money. It would have to spend a little bit more money, which then, if you do the math, that would be equivalent to $3.109 million, which is actually going to be more than what you would have spend with the forward contract. So hedging with liquidity is going to have this cost, okay? That's not the end of it. Now comes, actually, the most interesting discussion. That's why I have the picture of the Russian government there, right? Let’s think about what was happening in Russia at the end of 2014. Why was the Russian one-year rate, 17% is extremely high, right? For a one-year government bond rate. What was going on? What was happening is that Russia was in the middle of a currency crisis. On December 15th of 2014, as this actually comes from an article from The Economist, the currency lost 10% of its value in one day. [LAUGH] It had already lost 40% on that year, so what the central bank did is increase the interest rates sharply to try to calm the market. But there was desperation according to the economists, okay? So we are in the middle of a crisis and my hedging strategy seems very smart, but what I'm proposing is that the US company is going to invest in Russia. What's the problem? The problem is that Russian bonds were probably not risk free at the end of 2014, right? The US company maybe eliminates currency risk by doing that, but now you're exposed to significant credit risk. You have Russian bonds. Russian bonds at that time were a very risky security, probably have a low credit rating. We talked about credit ratings already, right? So that is going to create significant credit risk. Currency risk turns into credit risk. So, again, that's another problem of trying to use liquidity to hedge, you may not have the right asset, the safe asset that you need to get a perfect hedging strategy. Now the company needs to think about, is it really worthwhile hedging using Russian bonds or not? And the answer is not obvious, right? So that's the summary. Liquidity is always a possible alternative. It's always an alternative. Theoretically, at least, you can always think about a liquidity alternative, but you also have to consider the cost, okay? Liquidity will typically come with additional costs and risks. There is going to be a cost of carrying cash, there may be interest payments that are taxable. Interest parity may not hold if this is currency risk. And finally, as we discussed, you may introduce some credit risk in your strategy, which you have to think about to make sure that it's really worth using liquidity to hedge, okay? The bottom line, it's always difficult to give overall conclusions, but I think here the picture is pretty clear. The bottom line is that if a derivative is available, my guess is that it will probably be safer and cheaper, think about the Russia example. You could go in the forward market with an international bank that is a fairly reliable counter party and write a forward contract. You're not going to have to hold Russian bonds, etc, right? So that might be safer. It may be also be cheaper, because you don't have the other cost of holding liquidity. But in some cases, a derivative is not available. That's the commercial paper example, right? In that case, the best we could do is to have an imperfect hedge. And it seems very straightforward to borrow today instead of waiting for tomorrow. So in that case, liquidity may be a better tool. So I want you to always think about liquidity, but remember that if the derivative is available, it might actually be the way to go.