1. International Cash Management 28 Lecture

2. 21 - 2 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.

3. 21 - 3 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.

4. 21 - 4  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. Complications in Optimizing Cash Flows

5. 21 - 5 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.

6. 21 - 6 Short-Term Interest Rates as of February 2004

7. 21 - 7 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. Investing Excess Cash

8. 21 - 8 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. Investing Excess Cash Centralized Cash Management

9. 21 - 9 Determining the Effective Yield The effective yield on foreign investments r = (1 + i f )(1 + e f ) – 1 where i f =the quoted interest rate on the investment e f =the %  in the spot rate Investing Excess Cash If the foreign currency depreciates over the investment period, the effective yield will be less than the interest rate.

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11. 21 - 11 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. Investing Excess Cash

12. 21 - 12 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 short- term 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. Investing Excess Cash

13. 21 - 13 Use of the Forward Rate as a Forecast

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15. 21 - 15 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. Investing Excess Cash

16. 21 - 16 Deriving the Value of e f that Equates Foreign and Domestic Yields r =(1 + i f )(1 + e f ) – 1  e f =(1 + r ) – 1 (1 + i f ) r = 11%, i f = 14%  breakeven e f = -2.63%. If the foreign currency depreciates by less than 2.63%, the foreign currency deposit will be more rewarding. Investing Excess Cash

17. 21 - 17 Use of Probability Distributions

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19. 21 - 19 Probability Distribution of Effective Yield

20. 21 - 20 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. Investing Excess Cash

21. 21 - 21 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. Investing Excess Cash

22. 21 - 22 Source: Adopted from South- Western/Thomson Learning © 2006