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Mexcobre Case:

Bob Jensen at Trinity University

How did swaps reduce copper price fluctuation risk?IntroductionShortly after Salamon Brothers invented the interest rate swap financial instruments derivative in acontract between IBM and the World Bank in 1981, this type of derivative was used to manage risk

in a copper mining operation in a Mexican company called Mexicana de Cobre (Mexcobre), asubsidiary of a copper mining group in Mexicao called Group Mexico. The transaction eventuallyinvolved ten banks in several nations, a Belgian customer, multiple foreign currencies, andMexcobre itself.

Why do companies enter into swaps?In a simple (plain) vanilla swap, the purpose is usually to swap variable rate interest obligations forfixed-rate obligations. The firm with variable rate debt can often swap for a better deal than can beobtained directly on a fixed-rate loan. Reasons for this can be complicated. Sometimes it is amatter of timing. For example, when a firm acquires variable rate debt, that type of debt mayappear to be the best deal. With the passage of time, the firm may change its preference towardfixed-rate debt. Negotiating an interest rate swap may have lower transactions cost than paying offthe variable rate debt and refinancing with fixed-rate debt. The counter party in the swap, on the

other hand, may be willing to speculate or otherwise prefer to swap forvariable rate payments.

In more complex situations, there may be capital market inefficiencies that make interest rateswaps advantageous. Firms enter into swaps to either speculate or to hedge interest rate risk. Insome instances, fixed-rate debt cannot be obtained directly at any rate. For example, suppose acompany has low or even zero credit standing in a certain nation and negotiates to swap interestpayments with a company that has high credit standing in that nation. Swaps are often brokeredby international banks of high credit standing that eliminate credit risk of both parties to a swap. Inany case, swap cash flows are usually netted against each other so the default risk would be loweven if there were no payment guarantees. Direct loans often entail credit risk, especially if theborrower is from one nation and the lender is from another nation. Interest rate swaps account forover 70% of all financial instrument derivatives contracts. The reason is that they are a means of

reducing credit risk, transactions costs, and market risk in hedging and speculating contracts.

The Mexcobre copper exporting subsidiary of Groupo Mexico faced such enormous financial pricerisks that it was effectively denied access to international debt markets. At the same time, it waspaying a burdensome 23% interest rate to the Mexican Government. Through a complexinternational swap arrangement, Mexcobre managed to replace its high cost $251 million debt witha 11.48% fixed-rate interest payment that equates to 0.9567% per month.

How did Sogem from Belgium hedge political risk?

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A crucial part of the case came in reducing political risk in Mexico. Since so much labor is involvedin copper mining, the Mexican government is not likely to take drastic measures or impose taxesthat impede the mining and sale of copper. However, the government might impede cash flows.For example, suppose the Mexican government chooses to tax or otherwise impede interestpayments going to the ten banks outside of Mexico in an effort to protect its own loans to Mexicancompanies. The ten outside banks hedged against such political risk by avoiding cash paymentsfrom Mexico. This was accomplished with a purchase contract in which a firm called Sogem inBelgium agreed to purchase nearly 4,000 tons of copper each month at spot rates on the London

Mercantile Exchange (LME). Payments, however, went into an escrow account in a New York Bank.These funds, in turn, were used to service $251 million loaned to Mexcobre by ten banks.

How did a copper swap hedge copper price fluctuation risk?

If copper prices plunged, there was a possibility that the balance of funds in escrow in New Yorkwould not be sufficient to service the debt on the $251 million in loans to Mexcobre by ten banks.

The Bank in New York controlling the escrow account acted at the request of the ten lending banksto hedge against copper price movements. Banque Paribus was willing to swap with the escrowfund for variable copper prices and guarantee a fixed monthly price or $2,000 per ton on 4,000 tonsper month.

The contract with Mexcobre capped the return of the New York Banks to 0.9567% per month. Anyexcess cash from high copper prices above the capped loan rate were returned to Mexcobre.

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