Lecture Multinational financial management: Lecture 28 - Dr. Umara Noreen

Lecture

28

International Cash Management


Chapter Objectives


To explain the difference in
analyzing cash flows from a subsidiary
perspective versus a parent perspective;



To explain the various techniques used to
optimize cash flows;



To explain common complications in
optimizing cash flows; and



To explain the potential benefits and risks
of foreign investments.
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Complications
in Optimizing Cash Flows
 Company-related characteristics
¤

When a subsidiary delays its payments to
the other subsidiaries, the other
subsidiaries may be forced to borrow until
the payments arrive.

 Government restrictions
¤

Some governments may prohibit the use of
a netting system, or periodically prevent
cash from leaving the country.
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Complications
in Optimizing Cash Flows
 Characteristics of banking systems
¤

¤

The abilities of banks to facilitate cash
transfers for MNCs may vary among
countries.
The banking systems in different countries

usually differ too.

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Investing Excess Cash
• Excess funds can be invested in domestic
or foreign short-term securities, such as
Eurocurrency deposits, Treasury bills, and
commercial papers.

• Sometimes, foreign short-term securities
have higher interest rates. However, firms
must also account for the possible
exchange rate movements.
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Short-Term Interest Rates
as of February 2004

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Investing Excess Cash
Centralized Cash Management

• Centralized cash management allows for
more efficient usage of funds and possibly
higher returns.

• When multiple currencies are involved, a
separate pool may be formed for each
currency. Funds can also be invested in
securities that are denominated in the
currencies needed in the future.
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Investing Excess Cash
Centralized Cash Management

• Given the current online technology,
MNCs should be able to efficiently create a
multinational communications network
among their subsidiaries to ensure that
information about their cash positions is
continually updated.

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Investing Excess Cash
Determining the Effective Yield

• The effective yield on foreign investments
r = (1 + if )(1 + ef ) – 1
where if = the quoted interest rate on the
investment
ef = the % in the spot rate

• If the foreign currency depreciates over
the investment period, the effective yield
will be less than the interest rate.

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Investing Excess Cash
Implications of Interest Rate Parity (IRP)

• A foreign currency with a high interest
rate will normally exhibit a forward
discount that reflects the differential
between its interest rate and the investor’s
home interest rate.

• However, short-term foreign investing on
an uncovered basis may still result in a
higher effective yield.
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Investing Excess Cash
Use of the Forward Rate as a Forecast

• If IRP exists, the forward rate can be used
as a break-even point to assess the shortterm investment decision.

• The effective yield will be higher than the
domestic yield if the spot rate at maturity
is more than the forward rate at the time
the investment was undertaken.

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Use of the Forward Rate as a Forecast

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Investing Excess Cash
Use of Exchange Rate Forecasts

• Given an exchange rate forecast, the
expected effective yield of a foreign
investment can be computed, and then
compared with the local investment yield.

• It may be useful to use probability
distributions instead of point estimates, or
to compute the break-even exchange rate
that will equate foreign and local yields.
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Investing Excess Cash
Deriving the Value of ef that Equates Foreign
and Domestic Yields

r = (1 + if )(1 + ef ) – 1
ef = (1 + r ) – 1
(1 + if )

• r = 11%, if = 14%

breakeven ef = -2.63%.

If the foreign currency depreciates by less
than 2.63%, the foreign currency deposit
will be more rewarding.

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Use of Probability Distributions

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Probability Distribution of Effective Yield

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Investing Excess Cash
Diversifying Cash Across Currencies

• If an MNC is not sure of how exchange
rates will change over time, it may prefer
to diversify its cash among securities that
are denominated in different currencies.

• The degree to which such a portfolio will
reduce risk depends on the correlations
among the currencies.

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Investing Excess Cash
Use of Dynamic Hedging to Manage Cash

• Dynamic hedging refers to the strategy of
hedging when the currencies held are
expected to depreciate, and not hedging
when they are expected to appreciate.

• The overall performance is dependent on
the firm’s ability to accurately forecast the
direction of exchange rate movements.

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• Source: Adopted from SouthWestern/Thomson Learning © 2006

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