International Cash Management 28 Lecture. 21 - 2 Chapter Objectives To explain the difference in analyzing cash flows from a subsidiary perspective versus.

International Cash ManagementInternational Cash Management

2828 Lecture Lecture

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.

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Complicationsin 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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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.

Complicationsin Optimizing Cash Flows

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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 Ratesas of February 2004

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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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• 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.


Centralized Cash Management

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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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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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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.


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Use of the Forward Rate as a Forecast

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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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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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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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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 South-Western/Thomson Learning © 2006

International Cash Management 28 Lecture. 21 - 2 Chapter Objectives To explain the difference in analyzing cash flows from a subsidiary perspective versus.

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