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ABSTRACT
In this teaching note, the authors use an iconic London building, the Gherkin, as a motivation to understand exchange rates, cross exchange rates, and unhedged exchange rate risk. The famous tower was constructed in the early 2000s by Swiss Re, an insurance company, and then sold to investors as part of a sale-leaseback deal in early 2007. Unfortunately, the purchase was funded by a consortium of lenders using multiple currencies and leaving owners open to exchange rate risk. While partially hedging interest payments, the owners did not hedge the loans' principal and ultimately loan-to-value limits caused the building to fall into bankruptcy despite being fully leased. Hopefully the storyline piques student interest and promotes a better understanding of a topic that frequently challenges students.
Notes
1. In addition to the detailed instruction for classroom implementation, the authors will provide an appendix that contains some possible extensions of this case upon request, along with blank tables that can be used as handouts for conducting the exercise.
2. Photographs of the bombing and news stories are easily available from an Internet search.
3. All figures and amounts are assembled from publicly available sources and may differ from actual amounts owing to rounding or inaccuracy of public reports.
4. A capitalization rate is defined as a property's net operating income divided by the value of the property. Here, we assume that the rental income is the same as the net operating income.
5. Real estate is generally considered a riskier investment. This is in part due to the illiquid nature of real estate.
6. We have made some simplifying assumptions as the blended margin on the consortium of Swiss franc loans was 75 basis points over 3-month LIBOR (Wallace Citation2014). The average 3-month LIBOR between purchase and first default was 3.14 percent; including the 75 basis point margin, we rounded the rate to 3.9 percent. For simplicity of calculations and understanding, we used the same rate for the loans in British pounds.
7. The financial structure also included interest rate swaps, which have been omitted from the financial structure outline for simplicity and due to lack of clarity on the nature of the swaps.
8. Generating interest in the building will generate interest in the exercises; we believe it is worth putting some effort and time into the introduction.
9. Students may not be familiar with the three-character currency code notation; we usually explain that there are multiple currencies called the dollar, franc, peso, etc., and the currency code is a unique identifier for clarity.
10. Note that GBP 212 million plus GBP 184 m equals GBP 396 million, the amount financed.
11. As we stated above, Swiss Re paid at least some rent in francs. We are taking some creative license here to ask the students to consider a situation where rent is collected in pounds but the interest expense is paid in two currencies. Our motive is to illustrate how the exchange rate movements could impact cash flows for the firm.
12. We assume that students studying exchange rates are already familiar with the concept of supply and demand, at least at some level.
13. This presents an opportunity to discuss direct versus indirect quotes. Direct quotes are the amount of home currency per unit of the foreign currency, equivalent to $ per pizza. Indirect quotes, the amount of foreign currency per unit of the home currency, would be equivalent to the percentage of pizza traded for one dollar.
14. Depending on your course, you could give a longer explanation of the history of exchange rates, but to keep the lesson in a single class period the history may be omitted.
15. If not using FRED as part of the lecture or demonstration, it might be worth adding a figure to your lecture slides that demonstrates the exchange rate between the pound and the franc for the period 2005 to 2015. This figure will help illustrate the exchange rate risk that is discussed herein.
16. Note: if you want to teach triangular arbitrage, it could easily be included at this point.
17. Certainly, if one were to look on other Web sites, a GBP/CHF exchange rate could be found, but for our purposes the lack of a rate series in FRED is a stroke of good fortune.
18. For the instructor's benefit, we have created some supplemental materials that include a blank that could be used as a handout. It is available upon request from the authors.
19. If you are comfortable with Excel, you can bring a digital version of the table and fill in the cross exchange rates as the students calculate them, and then create a graph to see what happened to the value of the pound (the value of the rents received) over the time period.
20. For the instructor's benefit, we have created some supplemental materials that include a blank as a handout that can be used in class. It is available upon request from the authors.
21. We are taking some creative license here for the purposes of this teaching example. We assume here that the rental income was paid in pounds. In actuality this was not the case, and denominating the debt into two currencies made sense because it acted as a natural hedge against having a cash flow problem.
22. For this part of the exercise, we are using the yearly average exchange rate that can be found on FRED by switching from a monthly series to a yearly series.
23. At this point, the instructor can ask questions to build intuition about how movements in the exchange rate could affect the number of pounds needed to make the interest payment to the “franc” lenders. For example, the instructor could introduce the idea of flights to safety where currency investors flock to “safe” currencies in times of crisis.
24. We have created some supplemental materials to this teaching case that are available upon request.
25. In supplemental materials, which are available upon request, we provide a blank that can be used as handout. We also provide an answer key to the handout.