INTERNATIONAL FINANCIAL

MANAGEMENT

CHAPTER 21 -
INTERNATIONAL
CASH
MANAGEMENT
Lecture Objectives
• Explain working capital management from a subsidiary perspective
versus a parent perspective.
• Explain how cash management can be centralized in order to ensure
that cash is used more efficiently.
• Explain the various techniques used to optimize cash flows.
• Explain the decision to invest cash internationally.
Cash management is the optimization of cash flows and the
investment of excess cash.
Multinational Working Capital Management
Subsidiary Expenses
• The subsidiary will normally have a more difficult time forecasting future
outflow payments if its purchases are international rather than domestic
because of exchange rate fluctuations.

Subsidiary Revenue
• Subsidiaries’ sales volume may be more volatile than if the goods were
only sold domestically. Accounts receivable management is an important
part of the subsidiary’s working capital management because of its
potential impact on cash inflows.
Multinational Working Capital Management
Subsidiary Dividend Payments
• When dividend payments and fees are known in advance and
denominated in the subsidiary's currency, forecasting cash flows is easier.

Subsidiary Liquidity Management

• After accounting for all outflow and inflow payments, the subsidiary may
have excess or deficient cash. It uses liquidity management to invest
excess cash or borrow to cover cash deficiencies.
Centralized Cash Management

• Decentralized management is not optimal because it will

force MNC to maintain larger cash investment than
necessary.
• MNCs commonly use centralized cash management to monitor
and manage the parent-subsidiary and intersubsidiary cash
flows.
Exhibit 21.1 Cash Flow of the Overall MNC
Centralized Cash Management
Accommodating Cash Shortages: A key role of the centralized cash
management division is to facilitate the transfer of funds from
subsidiaries with excess funds to those that need funds.
• Technology Used to Facilitate Fund Transfers
o A centralized cash management system needs continual flow of information
about currency positions to determine whether one subsidiary’s shortage of
cash can be covered by another subsidiary’s excess cash.
• Monitoring of Cash Positions
o The centralized cash management division serves as a monitor over the
subsidiaries because it can detect potential financial problems.
Optimizing Cash Flows
Accelerating Cash Inflows using lockboxes and preauthorized
payments.
Minimizing currency conversion costs by netting, using a bilateral
netting system or a multilateral netting system. (Exhibits 21.2 and 21.3)
Managing blocked funds by incurring costs within the country or
using transfer pricing.
Managing intersubsidiary cash transfers by using a leading or
lagging strategy.
Exhibit 21.2 Intersubsidiary Payments Matrix
U.S. DOLLAR U.S. DOLLAR U.S. DOLLAR U.S. DOLLAR U.S. DOLLAR
VALUE (IN VALUE (IN VALUE (IN VALUE (IN VALUE (IN
PAYMENTS OWED BY THOUSANDS) THOUSANDS) THOUSANDS) THOUSANDS) THOUSANDS)
SUBSIDIARY OWED TO OWED TO OWED TO OWED TO OWED TO
LOCATED IN SUBSIDIAIRY SUBSIDIAIRY SUBSIDIAIRY SUBSIDIAIRY SUBSIDIAIRY
LOCATED IN LOCATED IN LOCATED IN LOCATED IN LOCATED IN
CANADA FRANCE JAPAN SWITZERLAND UNITED
STATES
Canada — 40 90 20 40

France 60 — 30 60 50

Japan 100 30 — 20 30

Switzerland 10 50 10 — 50

United States 10 60 20 20 —
Netting Payments
Investing Excess Cash
• Benefits of Investing in a Foreign Currency:
An MNC’s excess funds can be invested in domestic or foreign short-
term securities. In some periods, the foreign short-term securities will
have higher interest rates than domestic interest rates and may
therefore deserve consideration by MNCs that have excess short-term
funds available.
Investing Excess Cash
• Determining the Effective Yield — The effective yield of a bank
deposit considers both the interest rate and the rate of appreciation (or
depreciation) of the currency denominating the deposit and can
therefore be very different from the quoted interest rate on a deposit
denominated in a foreign currency.

rf = 1 + if 1 + ef − 1

where r = effective yield on foreign deposit

if = quoted interest rate
ef = percentage change in value of currency
Investing Excess Cash
• Risk of Investing in a Foreign Currency:
While an MNC might earn a higher effective yield from investing in a
deposit denominated in a foreign currency, its investment is subject to
risk, or uncertainty surrounding the effective yield.

• Hedging the Investment in a Foreign Currency

MNCs that want to invest their cash in deposits with a high foreign
interest rate may consider hedging their investment in an attempt to
avoid exposure to exchange rate risk.
Investing Excess Cash
Break-Even Point from Investing in a Foreign Currency:
• The forward rate can be viewed as a break-even point: If it represents
an accurate forecast of the future spot rate (which will exist at the end
of the deposit period), the effective yield on the foreign deposit will be
equal to the yield from investing domestically.
o Relationship with the International Fisher Effect — The international Fisher
effect suggests that the exchange rate of a foreign currency is expected to
change by an amount reflecting the difference between its interest rate and
the U.S. interest rate. The rationale behind this theory is that a high nominal
interest rate reflects an expectation of high inflation, which could weaken the
currency (according to purchasing power parity).
Investing Excess Cash
• Break-Even Point from Investing in a Foreign Currency
(continued)
Conclusions about the Forward Rate — Exhibit 21.4 summarizes
the key implications of interest rate parity and the forward rate as a
predictor of future spot rates for foreign investing.
Exhibit 21.4 Considerations When Investing Excess Cash

SCENARIO IMPLICATIONS FOR INVESTING IN FOREIGN DEPOSITS

1. Interest rate parity exists. Covered interest arbitrage is not worthwhile.

2. Interest rate parity exists, and the forward rate is an An uncovered investment in a foreign deposit is not
accurate forecast of the future spot rate. worthwhile.

3. Interest rate parity exists, and the forward rate is an An uncovered investment in a foreign deposit will on
unbiased forecast of the future spot rate. average earn an effective yield similar to an investment in
a domestic deposit.

4. Interest rate parity exists, and the forward rate is An uncovered investment in a foreign deposit is expected
expected to overestimate the future spot rate. to earn a lower effective yield than an investment in a
domestic deposit.

5. Interest rate parity exists, and the forward rate is An uncovered investment in a foreign deposit is expected to
expected to underestimate the future spot rate. earn a higher effective yield than an investment in a
domestic deposit.

6. Interest fate parity does not exist, and the forward Covered interest arbitrage is feasible for investors residing in
premium (discount) exceeds (is less than) the interest rate the home country.
differential.

7. Interest rate parity does not exist, and the forward Covered interest arbitrage is feasible for foreign investors but
premium (discount) is less than (exceeds) the interest rate not for investors residing in the home country.
differential.
 Investing Excess Cash
• Using a Probability Distribution to Enhance the Investment Decision
Since even expert forecasts are not always accurate, it is sometimes useful
to develop a probability distribution instead of relying on a single prediction
• Investing in a Portfolio of Currencies
Because an MNC cannot be sure how exchange rates will change over time, it may
prefer to diversify its cash among deposits denominated in different currencies.
Limiting the percentage of excess cash invested in each foreign currency will reduce
the MNC’s exposure to exchange rate risk.
Investing Excess Cash
Investing in a Portfolio of Currencies
• Because an MNC cannot be sure how exchange rates will change over time,
it may prefer to diversify its cash among deposits denominated in different
currencies. Limiting the percentage of excess cash invested in each foreign
currency will reduce the MNC’s exposure to exchange rate risk.
Exhibit 21.5 Analysis of Investing in a Foreign
Currency
POSSIBLE RATE OF CHANGE
IN THE AUSTRALIAN DOLLAR EFFECTIVE YIELD IF THIS RATE OF
OVER THE LIFE OF THE PROBABILITY OF CHANGE IN THE AUSTRALIAN
INVESTMENT (ef) OCCURRENCE DOLLAR OCCURS

+4% 70% (1.07)[1 + (.04)] − 1 = .1128, or 11.28%

−5% 30% (1.07)[1 + (−.05)] − 1 = .0165, or 1.65%
100%
Exhibit 21.6 Development of Possible Effective Yields
PROBABILITY OF
POSSIBLE THAT
PERCENTAGE PERCENTAGE COMPUTATION OF EFFECTIVE
CHANGE IN THE CHANGE IN THE YIELD BASED ON THAT
CURRENCY SPOT RATE OVER SPOT RATE PERCENTAGE CHANGE IN THE
THE DEPOSIT LIFE OCCURRING SPOT RATE

Australian dollar +4% 70% (1.07)[1 + (.04)] − 1 = 11.28%

Australian dollar −5% 30 (1.07)[1 + (−.05)] − 1 = 1.65%

100%
Mexican peso +2% 60% (1.06)[1 + (.02)] − 1 = .0812 or 8.12%

Mexican peso −4% 40%

100% (1.06)[1 + (−.04)] −1 = .0176 or 1.76%

Exhibit 21.7 Analysis of Investing in two Foreign
Currencies
Possible Joint Effective Yield
COMPUTATION COMPUTATION OF EFFECTIVE
AUSTRALIAN MEXICAN OF JOINT YIELD OF PORTFOLIO (50% OF
DOLLAR PESO PROBABILITY TOTAL FUNDS INVESTED IN EACH
CURRENCY)
11.28% 8.12% (70%)(60%) = 42% .5(11.28%) + .5(8.12%) = 9.70%
11.28% 1.76% (70%)(40%) = 28% .5(11.28%) + .5(1.76%) = 6.52%
1.65% 8.12% (30%)(60%) = 18% .5(1.65%) + .5(8.12%) = 4.885%
1.65% 1.76% (30%)(40%) = 12% .5(1.65%) + .5(1.76%) = 1.705%
100%
Investing Excess Cash
Dynamic hedging: Strategy of applying a hedge when the currencies held are
expected to depreciate and removing the hedge when the currencies held are
expected to appreciate.