1. SHORT-TERM FINANCIAL MANAGEMENT Chapter 16 – Managing Multinational Cash Flows

2. M ANAGING M ULTINATIONAL CASH FLOWS Chapter 16 Agenda 2 Discuss development of the current exchange rate system, understand the determinants of exchange rates fluctuations, discuss internal structures used to manage exchange rate fluctuations, and describe differences between U.S. and foreign banking systems.

3. Multinational Cash Flows 3  The issues associated with managing cash flows is exacerbated when conducting international transactions from exposure to foreign currencies.  Changes in exchange rates can benefit or harm a firm; our focus is on adverse affects.

4. Exchange Rates 4  The Foreign Currency Exchange Rate is the price at which one currency can be exchanged for another currency.  Risk sourced from exchange rates depends on the currency in which the transaction is denominated and the exchange rate between the two currencies at the time of settlement.  If the seller accepts payment in its home currency, the foreign exchange rate risk is transferred to the buyer.  If the seller accepts payment in the buyer’s currency, it retains the foreign exchange rate risk.

5. Exchange Rate Risk Illustrative 5  The chart below indicates exchange rates for selected countries.  Currency rates are market-driven and can change daily based on relative supply/demand for that currency.  Rates can be quoted per unit of foreign currency (‘direct quote’) or per unit of home currency (‘indirect quote’); they are the reciprocal of each other:

6. Spot and Forward Rates 6  Spot Rates (‘cash’) are currency exchange rates quoted based on immediate delivery.  Settlement occurs within two days.  The settlement date is called the ‘Value Date.’  Forward Rates are currency exchange rates contracted for settlement at a future date at a predetermined time and rate (‘lock’).

7. Forward and Futures Contracts 7  Both forward currency rate and futures exchange rate contracts have future settlement dates and the exchange rate is determined at the time the contract is consummated.  Forward contracts are individually negotiated between two parties (‘counterparties’) and must be held until maturity.  Futures contracts are standardized and exchange-traded and can be sold prior to expiration. Participants in futures are required to maintain properly-funded margin accounts with the exchange.

8. Factors Affecting Exchange Rates 8  Several factors can cause exchange rates to change:  The relative level of interest rates. Interest Rate Parity Hypothesis – Exchange rates will adjust to offset the differential in interest rates.  The relative rate of inflation. Purchasing Parity Hypothesis – Exchange rates will adjust to offset the relative inflation rates.  Government central-bank reaction to changes in exchange rates.  Economic and political factors.

9. FX Exposure 9  Multinational corporations face risk not experienced by firms conducting only domestic business.  The risks from floating exchange rates include:  Economic Exposure – The expected NPV of a long-term transaction is negatively affected.  Transaction Exposure – The sales (purchase) price associated with a contract will decrease (increase).  Translation Exposure – The financial statements of a foreign subsidiary of a domestic firm will suffer a loss once translated to the home currency.

10. Global Liquidity Management 10  Most multinational firms operate with a centralized treasury function.  To maximize global liquidity, firms are:  Building global liquidity pyramids, consolidating net cash positions at the national, broad regional, and enterprise levels.  Leveraging ERP (Enterprise Resource Planning).  Reducing the number of banks in their system.

11. Managing FX Exposure 11  Firms can manage exposure to uncertain future cash flows resulting from currency fluctuations either internally and/or through the use of derivatives.  Internal management techniques include:  Avoidance – While uncompetitive and likely to be impractical, firms only make and accept payments in the domestic currency.  Leading and Lagging – Accelerating (‘leading’) or delaying (‘lagging’) collections and/or payments timed based on expected changes in exchange rates.  Netting – Reducing net exposure for each foreign currency by netting daily cash inflows and outflows.

12. Netting Illustrative 12

13. Managing FX Exposure 13  A firm might use hedging strategies in addition to, or instead of, internal strategies, such as using forwards, futures, options, and swaps.  A Macrohedge manages the entire system taking into consideration offsetting currency fluctuations and hedging only the gap.  A Microhedge manages single transactions.

14. Non-U.S. Banking Systems 14  Non-U.S. banks operate differently from the domestic banking system in the following, important ways:  Check Clearing – Checks are ‘value dated,’ both forward value dated and back value dated  Interest Paid on Checking Accounts  Pooling  Government Policies Restrictions  Cash Management Services