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 7
 17.2 Short Term Borrowing and
Investment (contd.)
• The international Fisher open condition

- = e(A/B) (17.1)
i A i B Ŝ
e (A/B) : Expected depreciation of currency A against currency B
Ŝ

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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
i -i = Ŝe (A/B) + RP (17.2)
A B
• This coupled with the interest parity relation
implies
F(A/B) = Se (A/B) + RP (17.3)

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

the expected future spot rate

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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
M×i - (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
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