354 International Financial Management

Answers to End of Chapter Questions

1. International Cash Management. Discuss the general functions involved in international cash
management. Explain how the MNC’s optimization of cash flow can distort the profits of each
subsidiary.

ANSWER: The general functions of international cash management are optimizing cash flows and
investing excess cash. These functions combined will lead to efficient usage of funds.

When subsidiaries adjust their cash transactions between each other to reduce taxes or financing
costs, their individual performances are distorted. For example, a subsidiary that makes a late
payment to another subsidiary (due to its shortage of funds) benefits in that it avoided a short-term
loan by delaying payment. The recipient subsidiary was hampered due to not receiving funds
earlier (since the present value of the late payment is lower).

2. Netting. Explain the benefits of netting. How can a centralized cash management system be
beneficial to the MNC?

ANSWER: Netting is a centralized compilation of inter-subsidiary cash flows. It is designed to

reduce currency conversion costs and processing costs associated with payments between
subsidiaries. By specifying a single net payment to be made instead of all individual payments
owed between subsidiaries, transactions costs are reduced and cash flows may be forecasted more
accurately.

A centralized cash management system is beneficial in that it allows for netting, which can reduce
transactions costs and improve cash budgeting. In addition, it can increase yields on short-term
investments by pooling excess cash of various subsidiaries.

3. Leading and Lagging. How can an MNC implement leading and lagging techniques to help
subsidiaries in need of funds?

ANSWER: A subsidiary in need of funds would receive cash inflows from another subsidiary
sooner than is required. This early payment provides the necessary funds. If the subsidiary in need
of funds is making payment, it may be allowed by the MNC parent or recipient subsidiary to delay
on its payment.

4. International Fisher Effect. If a U.S. firm believes that the international Fisher effect holds, what
are the implications regarding a strategy of continually attempting to generate high returns from
investing in currencies with high interest rates?

ANSWER: High interest rate currencies will typically depreciate to offset their interest rate
advantage (on average) according to the IFE. Therefore, this strategy will on average provide
similar returns as a domestic investment, and the strategy is not worthwhile.

5. Investing Strategy. Tallahassee Co. has $2 million in excess cash that it has invested in Mexico at
an annual interest rate of 60 percent. The U.S. interest rate is 9 percent. By how much would the
Mexican peso have to depreciate to cause such a strategy to backfire?

1 + 9%
- 1 = - 31.875%
1 + 60%
Chapter 21: International Cash Management 355

ANSWER: If the peso depreciates by more than 31.875 percent, the effective yield on the
Mexican deposit will be less than the domestic yield.

6. Investing Strategy. Why would a U.S. firm consider investing short-term funds in euros even
when it does not have any future cash outflows in euros?

ANSWER: The interest rate on the euro may be higher, or the euro may have a high probability of
appreciating. Also the firm may invest in euros today to hedge a future payment in euros.

7. Covered Interest Arbitrage. Evansville, Inc., has $2 million in cash available for 90 days. It is
considering the use of covered interest arbitrage, since the euro’s 90-day interest rate is higher
than the U.S. interest rate. What will determine whether this strategy is feasible?

ANSWER: If interest rate parity exists, then the forward rate of the euro contains a discount that
sufficiently offsets the higher interest rate on euros. Consequently, the act of covered interest
arbitrage would not be feasible.

8. Effective Yield. Fort Collins, Inc., has $1 million in cash available for 30 days. It can earn 1% on
a 30-day investment in the U.S. Alternatively, if it converts the dollars to Mexican pesos, it can
earn 1 1/2% on a Mexican deposit. The spot rate of the Mexican peso is $.12. The spot rate 30
days from now is expected to be $.10. Should Ft. Collins invest its cash in the U.S. or in Mexico?
Substantiate your answer.

ANSWER: If Fort Collins Inc. invests in a Mexican deposit, it will convert $1 million to
8,333,333 pesos, which will accumulate to 8,458,333 pesos after one month (due to the 1 1/2%
interest rate). If the spot rate of the peso is $.10 after one month, the pesos will be converted to
$845,833, which is less than the amount of dollars the firm started with. Thus, the Fort Collins Inc.
should invest its cash in the U.S.

9. Effective Yield. Rollins, Inc., has $3 million in cash available for 180 days. It can earn 7% on a
U.S. Treasury bill or 9% on a British Treasury bill. The British investment does require
conversion of dollars to British pounds. Assume that interest rate parity holds and that Rollins
believes the 180-day forward rate is a reliable predictor of the spot rate to be realized 180 days
from now. Would the British investment provide an effective yield that is below, above, or equal
to the yield on the U.S. investment? Explain your answer.

ANSWER: If the forward rate is an accurate forecast of the future spot rate, then the return on a
foreign investment without covering the currency exposure will be the same as if it was covered.
The uncovered foreign investment, like the act of covered interest arbitrage, will generate a return
similar to the domestic return (given that interest rate parity exists).

10. Effective Yield. Repeat question 9, but this time assume that Rollins, Inc., expects the 180-day
forward rate of the pound to substantially overestimate the spot rate to be realized in 180 days.
356 International Financial Management

ANSWER: In this case, the future spot rate will be less than the forward rate. If it was equal to the
forward rate, the foreign return would have been similar to the domestic return for Rollins Inc. (as
explained in the answer to question 9). If the future spot rate is lower than the forward rate, the
U.S. firm will receive less when converting the pounds back to dollars. Thus, the foreign return is
expected to be less than the domestic return.

11. Effective Yield. Repeat question 9, but this time assume that Rollins, Inc., expects the 180-day
forward rate of the pound to substantially underestimate the spot rate to be realized in 180 days.

ANSWER: In this case, Rollins Inc. will receive more when converting the pounds back to dollars
than the amount necessary to match the domestic return. Thus, the foreign return is expected to be
greater than the domestic return.

12. Effective Yield. Assume that the one-year U.S. interest rate is 10% and the one-year Canadian
interest rate is 13%. If a U.S. firm invests its funds in Canada, by what percentage will the
Canadian dollar have to depreciate to make its effective yield the same as the U.S. interest rate
from the U.S. firm’s perspective?

ANSWER:

(1 + 10%) – 1 = about –2.65%

(1 + 13%)

13. Investing in a Currency Portfolio. Why would a firm consider investing in a portfolio of foreign
currencies instead of just a single foreign currency?

ANSWER: A portfolio of currencies reduces the probability of the foreign investment backfiring
due to depreciation in the currencies denominating the investment. If all funds are in an investment
denominated in a single foreign currency, risk of that currency substantially depreciating is
relatively high (compared to an entire portfolio of currencies substantially depreciating).

14. Interest Rate Parity. Dallas Co. has determined that the interest rate on euros is 16 percent while
the U.S. interest rate is 11 percent for one-year Treasury bills. The one-year forward rate of the
euro has a discount of 7 percent. Does interest rate parity exist? Can Dallas achieve a higher
effective yield by using covered interest arbitrage than by investing in U.S. Treasury bills?
Explain.

ANSWER: If interest rate parity (IRP) existed, the forward rate of the euro should have a discount
reflecting the interest rate differential:

Forward discount = (1 + 11%) – 1 = –4.31% (discount)

(1 + 16%)

Since the euro’s actual discount exceeds that percentage, IRP does not exist. However, Dallas
Company would achieve a lower effective yield if attempting covered interest arbitrage than if it
invests in U.S. Treasury bills, because the euro’s forward discount more than offsets the interest
rate differential.
Chapter 21: International Cash Management 357

15. Diversified Investments. Hofstra, Inc., has no European business and has cash invested in six
European countries, each of which uses the euro as its local currency. Are Hofstra’s short-term
investments well diversified and subject to a low degree of exchange rate risk? Explain.

ANSWER: The short-term investments are not well diversified, because the entire portfolio of
investments is denominated in euros. If the euro weakens against the dollar, the return on all short-
term securities denominated in euros will decline from the perspective of the U.S. firm.

16. Investing Strategy. Should McNeese Co. consider investing funds in Latin America countries
where it may expand facilities? The interest rates are high and the proceeds from the investment
could be used to help support the investment. When would this strategy backfire?

ANSWER: McNeese could benefit from investing at a high interest rate. However, this strategy
could backfire if the currency weakens over time, because McNeese Co. could have converted
dollars later (at the time of expansion) at a more favorable exchange rate. The tradeoff is a higher
interest rate if it invests funds now, versus a more favorable exchange rate if it invests funds later.

17. Impact of September 11. Palos Co. commonly invests some of its excess dollars in foreign
government short-term securities in order to earn a higher short-term interest rate on its cash.
Describe how the potential return and risk of this strategy may have changed after the September
11, 2001 terrorist attack on the U.S.

ANSWER: The attack on the U.S. caused short-term interest rates in the U.S. to decline, which
made foreign securities more attractive. Furthermore, the decline in U.S. interest rates and the
weak stock prices in the U.S. caused a decline in capital flows to the U.S. and could possibly
cause a decline in the dollar. If the dollar weakens, the return from investing in the foreign
securities is higher.

Advanced Questions
18. Investing in a Portfolio. Pittsburgh Co. plans to invest its excess cash in Mexican pesos for one
year. The one-year Mexican interest rate is 19%. The probability of the peso’s percentage change
in value during the next year is shown below:

Possible Rate of Change

in the Mexican Peso Over Probability of
the Life of the Investment Occurrence
–15% 20%
–4% 50%
0% 30%

What is the expected value of the effective yield based on this information? Given that the U.S.
interest rate for one year is 7%, what is the probability that a one-year investment in pesos will
generate a lower effective yield than could be generated if Pittsburgh Co. simply invested
domestically?
358 International Financial Management

ANSWER:

Effective Yield if this

Possible Rate of Rate of Change in the
Change in Peso Probability Peso Does Occur
–15% 20% (1.19) [1 + (–15%)] – 1 = 1.15%
–4% 50% (1.19) [1 + (–4%)] – 1 = 14.24%
0% 30% (1.19) [1 + (0%)] – 1 = 19.00%

E(r) = 20% (1.15%) + 50% (14.24%) + 30% (19.00%)

= 0.23% + 7.12% + 5.70%
= 13.05%

There is a 20% probability that the peso’s effective yield will be less than the domestic yield.

19. Effective Yield of Portfolio. Ithaca Co. considers placing 30% of its excess funds in a one-year
Singapore dollar deposit and the remaining 70% of its funds in a one-year Canadian dollar deposit.
The Singapore one-year interest rate is 15%, while the Canadian one-year interest rate is 13%. The
possible percentage changes in the two currencies for the next year are forecasted as follows:

Possible % Change in Probability of that

the Spot Rate Over Change in the Spot
Currency the Investment Horizon Rate Occurring
Singapore dollar –2% 20%
Singapore dollar 1% 60%
Singapore dollar 3% 20%
Canadian dollar 1% 50%
Canadian dollar 4% 40%
Canadian dollar 6% 10%

Given this information, determine the possible effective yields of the portfolio and the probability
associated with each possible portfolio yield. Given a one-year U.S. interest rate of 8%, what is
the probability that the portfolio’s effective yield will be lower than the yield achieved from
investing in the U.S.? (See Appendix 21.)

ANSWER:

Possible % Change Effective Yield Based on the

in the Singapore Dollar % Change in the Singapore Dollar
–2% (1.15) [1 + (–2%)] – 1 = 12.7%
1% (1.15) [1 + (1%)] – 1 = 16.15%
3% (1.15) [1 + (3%)] – 1 = 18.45%

Possible % Change in Effective Yield Based on the

the Canadian Dollar % Change in the Canadian Dollar
1% (1.13) [1 + (1%)] – 1 = 14.13%
4% (1.13) [1 + (4%)] – 1 = 17.52%
6% (1.13) [1 + (6%)] – 1 = 19.78%
Chapter 21: International Cash Management 359

Possible Joint
Effective Yield Computation of Computation of Effective
S$ C$ Joint Probability Yield of Portfolio
12.7% 14.13% (20%)(50%) = 10% .3(12.7%) + .7(14.13%) = 3.701%
12.7 17.52 (20%)(40%) = 8% .3(12.7%) + .7(17.52%) = 16.074%
12.7 19.78 (20%)(10%) = 2% .3(12.7%) + .7(19.78%) = 17.656%
16.15 14.13 (60%)(50%) = 30% .3(16.15%) + .7(14.13%) = 14.736%
16.15 17.52 (60%)(40%) = 24% .3(16.15%) + .7(17.52%) = 17.109%
16.15 19.78 (60%)(10%) = 6% .3(16.15%) + .7(19.78%) = 18.691%
18.45 14.13 (20%)(50%) = 10% .3(18.45%) + .7(14.13%) = 15.426%
18.45 17.52 (20%)(40%) = 8% .3(18.45%) + .7(17.52%) = 17.799%
18.45 19.78 (20%)(10%) = 2% .3(18.45%) + .7(19.78%) = 19.381%
100%

There is a 0% chance that the portfolio will generate a lower return than a U.S. investment
(determined by the table above).

Solution to Continuing Case Problem: Blades, Inc.

1. There is a tradeoff between the higher interest rates in Thailand and the delayed conversion of
baht into dollars. Explain what this means.

ANSWER: If the net baht-denominated cash flows are converted into dollars today, Blades is not
subject to the expected depreciation of the baht, which would result in the conversion of the baht
into fewer dollars. However, if the baht are converted into dollars today, they would be invested in
the United States at an interest rate of only 8 percent versus the 15 percent interest rate available in
Thailand.

2. If the net baht received from the Thailand subsidiary are invested in Thailand, how will U.S.
operations be affected?

ANSWER: If the cash flows generated in Thailand are invested in Thailand, then Blades will have
to borrow additional funds in the U.S. at an interest rate of 10 percent in order to support its U.S.
operations. Furthermore, Blades will not be able to invest some of the remitted funds in the U.S. at
an interest rate of 8 percent. If the baht will depreciate by 5 percent over the next year as is
currently anticipated, then the Thai investment will render a yield of roughly 9.25 percent ([1.15 ×
0.95] – 1).

3. Construct a spreadsheet that compares the cash flows resulting from two plans. Under the first
plan, net baht-denominated cash flows (received today) will be invested in Thailand at 15 percent
for a one-year period, after which the baht will be converted to dollars. Under the second plan, net
baht-denominated cash flows are converted to dollars immediately and 60 percent of the funds will
be used to support U.S. operations, while 40 percent are invested in the U.S. for one year at 8
percent. Which plan is superior given the expectation of the baht’s value in one year?