A way to assess the bond swap

The calculation of present value is a valuable tool of analysis in today's financial world. When managed by rookies or people with wrong intentions it can be very dangerous, as all tools are. This is good to keep in mind when issuing judgment on Venezuela's 1997 Brady Bond swap. The concept of present value can be clearly illustrated by using the classic example of inheritance. In this example, someone asks a grandchild for the amount he is willing to trade today for a future inheritance of $1 million, which will be willed him by his grandmother. The answer to this question will be a function of three factors.

The first factor involved is time. If the grandchild considers that the grandmother is still healthy and that she therefore may live for quite a few more years (say 20 years), then he will obviously be willing to apply a greater discount and accept a lower present value. On the other hand, should the grandmother be rather ill, and death apparently just around the corner, then this discount will be smaller and the amount of the inheritance will be greater.

The second relevant factor is risk. This is based on the philosophy that it is better to have one bird in hand than a hundred in the bush. Should the grandchild think that his grandmother may actually change her mind and leave him penniless, he will again be willing to apply a greater discount and therefore accept a lower value today.

The third factor that must be mentioned is opportunity cost - in other words, the alternative use that maybe made of the funds. If the grandchild urgently needs the funds to pay off a gambling debt before someone breaks his kneecaps, it is obvious that he gill accept a greater discount and again accept a lower sum as present value of his inheritance . If, on the contrary, he expects to invest the funds in long term 30-year United States Treasury bonds, the discount he will offer will not defer too drastically from the yield produced by these instruments.

The risk factor and the opportunity cost factor come together in what we know as the discount rate. The mathematical process whereby present values are calculated consists in discounting (at the discount rate) the amount being analyzed (the inheritance) over an established period (time).

At this point, we have only come to the conclusion that even when we hide this calculation under the mantle of sophisticated financial techniques, there is a fundamental logic to the same. The value of something in the future is lower than it is today.

Having herewith complied with the initial objective of this article – to transmit as concisely as possible the concept of present value - let's now examine how this can be abused. The recent case of the Brady Bond swap was based on the analysis of supposed benefits found in two arguments: first, the fact that financial experts loudly praised the operation; and second, the analysis of the present value of the operation.

As far as the source of the praise, I do not wish to go into detail. But initially it seems that $28 million in commissions plus information of great income generating potential should be enough to justify the creation of a good Swap Fan Club.

As a result of the swap, Venezuela obtained $1.3 billion. The present value of this evidently is the same $1 .3 billion. In exchange, Venezuela had to undertake additional payments. These payments are: additional annual interest of $70 million over-- a 23-year period until 2020 as well as $370 million to be paid for seven years between the years 2021 and 2027. A final payment of $4 billion is due in the year 2027.

The classification of this operation as "financially sound" depends on whether or not the present value of the additional payments described in the previous paragraph is lower than the $1 .3 billion received initially. It all depends on the infamous discount rate applied. With a discount rate of 8.8 percent, the operation is neutral (Blah Matos). With a higher rate, the operation could be rated as marvelous (Viva Matos!). Finally, with a lower discount rate, the operation is an unmitigated disaster (Down with Matos!).

We will not issue opinions about who is right. I would like though to alert readers about the vicious circle caused by the erroneous use of the present value principle which, in the hands of the wrong people (politicians maybe?) could generate catastrophic results.

Because it has implemented shortsighted policies, Venezuela has problems of high indebtedness. When the country runs into problems, the discount rate applied by international markets is normally increased. When the rate is increased the value of the present value of future payments is reduced. When the value of the future payments is reduced, additional indebtedness is stimulated. And the vicious circle continues to turn!