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 20072009 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,
deviations to the base case. three different scenarios should be compared in order to illustrate the results and

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

Case Study. Principles and Practices of Finance; Beta Bartalos

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.

Case Study. Principles and Practices of Finance; Beta Bartalos

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