CHAP17A

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International Financial Management

P G Apte

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17.1 Introduction

• The essence of short term financial management can be stated as – Minimize the working capital needs consistent

with other policies – Raise short term funds at the minimum possible

cost and deploy short term cash surpluses at the maximum possible rate of return consistent with the firm's risk preferences and liquidity needs

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17.1 Introduction (contd.)

• In a multinational context, the added dimensions are the multiplicity of currencies and a much wider array of markets and instruments for raising and deploying funds

• Focus on cash management since it is complex because of possibility of raising and deploying cash in many currencies, many locations, and profit opportunities presented by imperfections in international money and foreign exchange markets

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17.1 Introduction (contd.)

• Even a purely domestic firm or a firm with imports and exports but no cross-border manufacturing facilities can "internationalize" its cash management if the government of the country permits free capital inflows and outflows

• In India as of now, the capital account has not been opened up

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17.1 Introduction (contd.)

• Indian firms have been permitted access to foreign money markets (through domestic banks) for preshipment credits for exports and settlement of import payments

• The Exchange Earners Foreign Currency (EEFC) account facility

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17.1 Introduction (contd.)

• The passive approach confines itself to minimizing cash needs and currency exposure as well as optimal deployment of cash balances arising out of the firm's operating requirements

• The active approach deliberately creates cash positions to profit from perceived market imperfections or the firm's supposedly superior forecasting ability

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17.2 Short Term Borrowing and Investment

• The principal dimensions of the borrowing-investment decisions are the instrument, currency, location of the financial center and any tax related issues

• On a covered basis, the choice of currency of borrowing does not matter.

• Only when the borrower firm holds views regarding currency movements which are different from market expectations as embodied in the forward rate, does the currency of borrowing become an important choice variable

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17.2 Short Term Borrowing and Investment (contd.)

• The international Fisher open condition

(17.1) (A/B)Se = i - i BA

Bcurrency against A currency ofon depreciati Expected:(A/B)Se

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17.2 Short Term Borrowing and Investment (contd.)

• If speculators are risk averse, a risk premium must be incorporated in the above relationship

• This coupled with the interest parity relation implies

• F(A/B) is the relevant forward rate and Se(A/B) is the expected future spot rate

(17.2) RP + (A/B)Se = i

B - i

A

(17.3) RP + (A/B)Se = F(A/B)

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17.2 Short Term Borrowing and Investment (contd.)

• The risk premium can be negative or positive depending upon whether speculators as a group are required to be net short or long in the forward market

• The forward rate can on average equal the future spot rate even in the presence of a constant risk premium

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17.2 Short Term Borrowing and Investment (contd.)

• Following the same reasoning, on a covered basis the firm should be indifferent between various currencies when it comes to placing temporary excess funds since the covered yields are identical

• Considerations such as availability of various investment vehicles- deposits, CDs, CP, treasury bills etc.- and their liquidity may lead to one currency being favored over another

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17.3 Where should Surplus Cash be

Held? • Apart from cost and return considerations,

several other factors influence the choice of currencies and locations for holding cash balances

• The bid-ask spreads in exchange rate quotations represent transaction costs of converting currencies into one another

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17.3 Where should Surplus Cash be Held? (contd.)

• Minimizing transaction costs• Liquidity: Funds should be held in a

currency in which they are most likely to be needed

• Political risk• Availability of investment vehicles and

their liquidity • Withholding taxes

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17.3 Where should Surplus Cash be Held? (contd.)

• Investing surplus funds– Choose appropriate investment vehicles so as to

maximize the interest income while at the same time minimizing currency and credit risks and ensuring sufficient liquidity to meet any unforeseen cash requirements

– The major investment vehicles available for short-term placement of funds are short term bank deposits, fixed term money market deposits such as CDs and financial and commercial paper

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17.3 Where should Surplus Cash be Held? (contd.)

– Main considerations in choosing an investment vehicle

• Yield

• Marketability

• Exchange Rate Risk

• Price Risk

• Transactions Costs

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17.3 Where should Surplus Cash be Held? (contd.)

– Let M denote the minimum size of the investment instrument, S the surplus funds, i the interest on the instrument, d the interest rate on the bank deposit and b the interest rate on borrowing or overdraft

– Breakeven size of excess funds is given by

Mi - (M-S*) b = S* d

i.e. S* = M[(b-i)/(b-d)]

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17.3 Where should Surplus Cash be Held? (contd.)

– If excess funds on hand exceed S*, money should be borrowed to invest in the money market instrument; otherwise the excess funds should be left in a bank deposit

• Financing Short-Term Deficits – Careful handling of short-term deficits can lead to

significant savings

– Minimize the overall borrowing requirement consistent with the firm's liquidity needs and to fund these at the minimum possible all-in cost

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17.3 Where should Surplus Cash be Held? (contd.)

– One of the cheapest ways of covering short-term deficits is internal funds

– A centralized cash management system with cash pooling described below can efficiently allocate internal surpluses

– External sources of short-term funding consist of overdraft facilities, fixed term bank loans and advances and instruments like commercial paper, trade and bankers' acceptances

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17.4 Centralized Management Versus Decentralized Cash Management

• Centralized cash management has several advantages – Netting– Exposure Management– Cash Pooling

• Disadvantages of centralized management– Some funds have to be held locally in each

subsidiary to meet unforeseen payments

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17.4 Centralized Management Versus Decentralized Cash Management

(contd.)

– Local problems in dealing with customers, suppliers etc.

– Conflicts of interest can arise if a subsidiary is not wholly owned but a joint venture with minority local stake

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17.5 Cash Transmission

• Minimizing the unnecessary costs in the process of collecting cash from debtors and making payments to creditors; the costs arising from the so called "float"

• The treasurer must try and minimize the float in the cash collection cycle and take advantage of the float in the cash payment cycle

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17.5 Cash Transmission (contd.)

• The banking systems in various countries have evolved clearing mechanisms which aim at reducing the delays between a payment instruction being received and the payee actually being able to apply the funds

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17.6 Summary

• Within the constraints imposed by the exchange control and other regulations, a MNC has access to a much wider menu of funding avenues and investment vehicles for short-term funds management

• Apart from funding and investment avenues, the mechanics of efficient cash transmission and configuration of bank accounts is an important aspect of cash management in a MNC

• The decision to centralize cash management in a separate cash management center needs to be carefully evaluated