THE CHALLENGES OF CROSS-BORDER PROJECT VALUATION



Topics: Foreign exchange exposure / Fair valuation / FX Forward


The fair valuation of a cross-border equity investment with regards to the currency risk is quite a challenge. As the net investment return of the project in the base/home currency also depends on the foreign currency performance, it is essential to correctly price the foreign currency future cashflows.


When analysing such a project, especially if it is a long-dated project, equity investors often wonder how to project the foreign exchange parity in the future, and a multitude of approaches are traditionally used:


  • Some use FX forwards

  • Some use diverse sources of FX forecasts that can deviate very significantly from FX forwards (e.g., based on the Purchasing Power Parity or inflation differentials)

  • Some even use a variety of averages between spot FX rates and forwards or forecasts or have different approaches for the first years and thereafter

When discussions arise as to what should be the “fair parity” to use in order to compute the “fair value” of the project or investment target, debates can be passionate as the impact of this assumption on the pricing is potentially very high, and as competition in the investment market is currently fierce.


This newsletter addresses the issue by analysing the nature of FX forwards, presenting the rationale of using them to evaluate future foreign currency flows, and highlighting the uses and implications of FX forecasts as an alternative projection assumption.


Preamble


As a preamble, let us draw a parallel with similar situations in the equity markets.


Imagine you are back on December 31st, 2019, and the Amazon Inc shares trade at $1848 spot, and a one-year forward on the Amazon Inc share trades at $1888 (+2.16% vs spot). If you consider buying Amazon one-year forward, $1888 is the “fair” price as it results from a market equilibrium. This is the level at which you can fix the price forward.


However, either the spot or the forward on that date will reveal to be a poor forecast for the share value one year later in December 2020 as it ended up trading at $3257 on December 31st, 2020 (+76.24% vs Dec2019 spot).


Deviating from the forward is taking a biased bet on FX parities

However, either the spot or the forward on that date will reveal to be a poor forecast for the share value one year later in December 2020 as it ended up trading at $3257 on December 31st, 2020 (+76.24% vs Dec2019 spot).


The fair value was the forward but accepting to pay a premium of 10% in December 2019 to buy the shares forward as a bet that the stock price was going to strongly beat the forwards would have revealed profitable even if the price paid deviated from the forward.


In the foreign exchange world, the situation is similar: the FX forward is the “fair” projection and deviating from the forward is taking a biased bet on FX parities.


The uses of a “fair valuation”


Evaluating a project or a company can be done with different goals:


a. Comparing investments in different currency zones or on different tenors

b. Decide on the price to submit in a bidding contest


In order to compare different investment opportunities, the valuation of the project must not only be consistent with the price of other risky assets in the same foreign currency, but it must also be consistent with the valuation of similar projects denominated in other currencies.


To value the foreign cashflows[1] of a project in a base currency using a Discounted Cash Flow approach (“DCF”), there are two routes that are poised to give consistent results in an arbitrage free world: the foreign currency (“FC”) route and the base currency route (“BC”).

[1] We assume here that the cashflows are not correlated to the FX spot rates or the interest rates


The FX forwards are precisely defined in a way that the project value does not depend on the chosen approach, both giving the same value in the base currency: A forward FX rate depends on the spot rate and of the interest rate differential between the Foreign currency and the base currency.


Converting the foreign currency flows into base currency flows using the forwards ensures consistency with the interest rate markets in both currencies. It also ensures consistency with the way a local investor would value the project, and allows that, from the currency risk perspective, all investors value the project the same way, the essence of the competition lying elsewhere, in the industrial bet.


Using the FX forwards also allows to compare the investment with other investments in the same currency. For example, if a European investor were to invest in a project in South Africa that was carrying essentially only sovereign credit risk, this project should have a comparable pricing to that of a local government bond. Given that the local government bond is priced with the left-hand method described in the diagram, not using the forward FX projections creates a strong bias in comparing the value of the project v.s. the value of a comparable local investment, even though there is no fundamental difference.


For example, on the South Africa 8.75 02/2048 bond in ZAR, the USD yield would appear at 7.50% using the bond market price in ZAR and a PPP method to convert the ZAR cashflows in USD (with a 2.75% inflation differential between the US and South Africa in line with the average differential over the last 5 years). However, a direct USD bond issued by South Africa with a similar duration exists in the market and trades with a yield of 4.25% i.e. 3.25% lower. This suggests that the underlying assumption that leads to a yield of 7.5 % is questionable.


A “fair valuation” must be consistent with the pricing of similar projects in other countries and consistent with the pricing of other risky assets in the same currency.


The FX forward is the “fair” projection and deviating from the forward is taking a biased bet on FX parities. It is obvious for the liquid tenors where making a different assumption in FX markets than where the market is actually trading is a bet with negative inception value if there is a premium paid versus the actual forward FX rate. Should it be different in less liquid currency pairs and tenors? This diagram also shows that if there is no liquid FX forward market but liquid interest rates market in both currencies, the conversion should be based on the theoretical FX forward (i.e. FX spot rate multiplied by the ratio of the discount factors in each currency for the relevant maturity).


Opening the possibility of FX hedging


If there is a liquid FX forward market on this currency pair, the FX forward is the only projection that can be pre-fixed, thereby eliminating the foreign currency risk on the project. This implies that when this asset value is considered, the hedging / no hedging decision has no impact on the asset value. Hedging or not hedging is only a risk appetite decision.


Conversion of the foreign flows according to the FX forward gives the “fair” value

On the other hand, if the asset “fair value” is determined with FX projections that differ strongly from the forwards, most often resulting in a pumped-up value for the asset, the hedging decision then appears as having a very high cost versus not hedging. And this deters the investor from hedging the FX risk, thus creating a strong bias towards projects with a high currency risk that is not valued anywhere in the models.


Therefore, the conversion of the foreign flows according to the FX forwards (market-based or derived from the interest rates) gives the “fair” value of the asset (for example in the case of an acquisition) no matter if a FX hedge is put in place or not. This obviously does not mean that FX forwards are good forecast of the FX spot at maturity.


As a parallel, projecting different FX levels than the actual forwards FX rates is not substantially different from using lower levels of interest rates than the mid-swap fixed rates available in the local currency in order to compute the expected return of a project. In this case as well, financing with a floating rate (if allowed by the lenders) can potentially result in a better realized return than locking in a mid-swap fixed rate at a higher level. Using more aggressive FX rates than forwards (like forecasts) is actually the same logic as using lower fixed rates in the local currency than fixed rates actually available in the market to finance the project.


Using forecasts to establish the asset valuation?


When bidding on an asset in a fierce competitive environment, it can be tempting to use FX forecasts deviating significantly from FX forwards to value the asset. Quite often, this is done with the view that FX forwards are a poor predictor of future FX rates.


And it is true. FX forwards are poor predictors of future FX rates, as are spot FX rates, or forecasts based on a Purchase Power Parity or inflation differentials.


As a reference on this subject, the Swedish Riksbank published an article last year about the challenges of making forecasts for the future level of the Swedish Krona:


[…] seen over a longer period, the estimated exchange rate pass-through to aggregate inflation in Sweden is, on average, low. (…) Even in a general equilibrium model, it can be difficult to capture everything of significance for the relationship between the exchange rate and inflation. This applies, not least, when structural changes take place in the economy […].

Sveriges Riksbank, paper NO. 13 2019, 4 Dec 2019[2]


[2] https://www.riksbank.se/globalassets/media/rapporter/ekonomiska-kommentarer/engelska/2019/perspective-on-the-krona-inflation-and-monetary-policy.pdf


So, forecasting future FX rates using one method or the other is a difficult and risky exercise. Economists who try it are wrong about 50% of the time and it is very easy to find opposite forecasts from excellent economists. As mentioned above, using forecasts that differ substantially from the FX forwards to establish the asset valuation strongly deters from hedging the FX risk and destroys comparability between projects. But it has another strong implication that must not be overlooked: When the initial valuation of the asset is based on the assumption of FX forecasts substantially more aggressive than the FX forwards, it means that a substantial part of the return on the asset is expected from the bet on the currency. But taking a bet on FX can be achieved simply and at better conditions, both in price and liquidity, in the FX or bond market. Using an infrastructure project or a M&A transaction to essentially take a currency exposure is indirect and somewhat strange. In any case, it is important when analysing the project to identify what part of the IRR is coming from the industrial project, and what part is coming from the bet that FX rates will not follow the forwards. And to do this, it is necessary to build an alternative version of the model, based on the FX forwards. When the currency risk is not hedged, it is also important to measure the currency risk and the impact of an adverse change on the profitability of the project.


FX forecasts can then be useful to quantify what additional profit (or loss) on the project could arise from the currency exposure. Risky assets in the same foreign currency should then be valued with the same assumptions and their risk/return profiles compared with the project risk metrics.

Conclusion


FX forwards are certainly a poor predictor of future FX rates. But so are any FX forecasts, even those based on Purchasing Power parity, or the views of such or such economist. When evaluating a foreign currency asset, preserving the comparability between different investments is critical. Thus, we at ESTER strongly recommend to always build one valuation based on the forward FX rates, so as to be able to identify what part of the IRR is coming from the industrial project, and what part is coming from the bet that FX rates will not follow the forwards.

ESTER can of course provide you with assistance in these areas.

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