International Short-Term Financing and Investment

9.1 WHY FOREIGN CURRENCY FINANCING AND INVESTMENT?

International short-term financing and investment (also called international asset and liability management, working capital management and treasury management) involve the selection of the short-term assets and the short-term funds (liabilities) required to finance the assets, with the objective of maxi­mising the value of the firm. The difference between domestic and interna­tional short-term investment and financing operations is that the latter include the impact of exchange rate fluctuations, potential exchange controls and multiple tax jurisdictions, in addition to the fact that they also involve a wider range of financing sources and investment outlets. We will consider these decisions with reference to a multinational firm that has subsidiaries located in various countries and operating with different base currencies.

Multinational firms typically resort to financing their short-term operations and investing their surplus cash balances by using short-term instruments denominated in a variety of currencies. This kind of behaviour is motivated by the desire to (i) minimise (or reduce) the cost of borrowing; (ii) maximise (or increase) the rate of return on short-term investment; (iii) minimise risk; and (iv) find a better risk-return trade-off. Another consideration is that markets for short-term funds offer different degrees of liquidity and wider ranges of the underlying assets. There are also some tax considerations, as the cost of borrowing and the rate of return on short-term assets may differ significantly for tax-related reasons. Last, but not least, short-term financial operations utilising currency portfolios (rather than single currencies) may involve lower risk resulting from diversification.

i

We have to bear in mind that foreign currency financing and investment introduce foreign exchange risk if the firm does not already have such an exposure. If, on the other hand, the firm already has exposure to a foreign

currency, this exposure may actually be reduced by foreign currency financing and investment operations. Suppose that a firm whose base currency is x has payables and receivables in currencies y and z respectively due some time in the future. This firm is obviously subject to foreign exchange risk because the x-currency values of these payables and receivables are not known until they are realised. This risk can be reduced if the firm takes long and short positions on y and z respectively with the same maturity date on which the payables and receivables are due. In fact, even long and short posi­tions on other currencies that are highly correlated with y and z against x will reduce risk.

Of course, interest rates on various currencies may differ significantly, although they tend to be highly correlated. This naturally implies that the cost of borrowing and the rates of return on positions in various currencies may differ significantly. Figure 9.1 shows time plots of the three-month interest rates on four major currencies. While each of these interest rates represents the cost of borrowing for a borrower whose base currency is the currency in question, this is not true for a borrower with a different base currency. This is because foreign currency operations introduce another element to the cost of borrowing and the rate of return, which is the percentage change in the exchange rate. Thus, the cost of borrowing and the rate of return on foreign currencies are measured respec­tively by the effective financing rate and the effective rate of return. These concepts will be introduced later.

9.2 SOURCES OF FINANCING AND INVESTMENT OUTLETS

In this section we describe the sources of short-term financing and investment outlets (instruments) used to invest surplus funds. We start with the sources of short-term financing.

Sources of short-term financing

Before resorting to external financing, a business firm normally determines whether or not internal funds are available. A multinational firm with interna­tional subsidiaries can, for example, utilise internal financing by requesting a transfer of surplus funds from one of its subsidiaries. Another method, which produces the same effect, is to increase markups on supplies sent by the multi­national firm to subsidiaries with surplus funds. In this case, transfer pricing is used as the means for transferring funds from the subsidiary to the parent firm. The same procedure can be used to transfer funds from the parent firm to a subsidiary or from a subsidiary to another. This is generally known as intercompany or inter-subsidiary financing. If internal funds are not available, then the firm would resort to external financing, which may take the form of bank loans or raising funds by issuing short-term securities. These sources of

9.2 SOURCES OF FINANCING AND INVESTMENT OUTLETS

20 15 10

5. 0

Mar-80 Mar-84 Mar-88 Mar-92 Mar-96 Mar-00 Japanese yen

14. 12 10

8

4. 2 0

Mar-80 Mar-84 Mar-88 Mar-92 Mar-96 Mar-00 20

15. 10

4. 0

Mar-80 Mar-84 Mar-88 Mar-92 Mar-96 Mar-00

25 20 15 10 5 0

251

US dollar

UK pound

Canadian dollar

Mar-80 Mar-84 Mar-88 Mar-92 Mar-96 Mar-00 FIGURE 9.1 Three month interest rates on major currencies.

external funds may be found in the domestic market or the Eurocurrency market.

Bank loans, which are typically unsecured, are the dominant form of short- term financing. The borrower signs a note documenting its obligation to

repay the loan when it is due along with the accumulated interest. The loan must be repaid over the specified period (say three months) or renewed, which is called rolling over the loan. The process of rolling over gives the bank some control over the use of funds. To ensure that the funds are not used for long-term objectives, the bank may require a cleanup clause, which requires the borrower to be completely out of debt for a minimum period every year.

Bank loans may take one of several forms. Term loans are unsecured straight loans extended for a fixed period of time (for example, three months). They are used by borrowers who have infrequent need for bank credit. Another form is the line of credit, which is an informal agreement that permits a firm to borrow up to a maximum amount. It involves an agreement whereby the firm can draw down the line of credit and pay when it can. This agreement (which is valid over a year and renewable) is used by frequent borrowers. An overdraft, on the other hand, is a line of credit against which the borrower can issue cheques. Revolving credit arrangements are similar to overdrafts except that the lending bank is obliged to provide the funds (which is not the case for overdrafts). The borrower pays interest on the outstanding amount plus a commitment fee. When the arrangement is renewed continuously the risk arises that it may be used for long-term purposes, in which case a cleanup clause may be required.

Discounting is a mode of bank financing associated with bankers' accep­tances. When a bill resulting from a transaction (promising payment some time in the future) is presented to a bank, and the bank endorses the bill, it becomes a bankers' acceptance. The bill can then be sold at a discount to the bank or to a money market dealer. Another form of discounting is factoring, which arises when a firm's receivables are bought at a discount, thereby accel­erating their conversion into cash. A special kind of factoring is forfeiting, which is the discounting (at a fixed rate without recourse) of export receiv­ables in fully convertible currencies.

Raising funds can be accomplished by issuing short-term securities in the domestic market or the Eurocurrency market. These securities may take the form of note issuance facilities (NIFs) or commercial papers (CPs). Note issu­ance facilities are short-term notes underwritten by banks or guaranteed by bank standby credit arrangements. They are attractive to investors because they offer high liquidity through an active secondary market. In the case of revolving underwriting facilities (RUFs), borrowers use a single bank to place their paper at a set price.

Commercial papers are short-term unsecured promissory notes that are generally sold by large firms on a discount basis to institutional investors and other firms. Because they are unsecured, only large well-known firms can issue them. By going directly to the market rather than through financial inter­mediaries, issuing firms can make substantial savings

Short-term investment outlets

International short-term investment is the activity of placing excess funds or cash balances in the short-term instruments that are available in international money markets and denominated in various currencies. The word "placing" here has the same meaning as "lending", "depositing" and "investing".

Two instruments are predominantly used for short-term international investment, which are basic types of deposit instruments: time deposits and certificates of deposit (CDs), both of which may again be domestic or Eurocurrency instruments. Other money market instruments include Trea­sury bills, demand deposits, deposits with NBFIs, bankers' acceptances and commercial papers.

The placement of a Eurocurrency time deposit implies that the depositor commits the underlying funds for a specified period of time at a specified interest rate. On maturity, the depositor receives the amount invested (prin­cipal) and the interest paid on the principal. The maturities of short-term time deposits range between overnight and twelve months.

Certificates of deposit (CDs) comprise a smaller percentage of the total value of these instruments than time deposits. The attractiveness of these instru­ments as compared with time deposits stems from their property of being negotiable (that is, they can be bought and sold on a secondary market). A CD specifies the amount of the deposit (the principal), the date of maturity and the interest rate applicable to the principal. There are normally three types of CD: (i) tap CDs, which are large-denomination fixed-term deposits; (ii) tranche CDs, which are divided into several portions, making them appealing to smaller investors; and (iii) rollover CDs, which are renewed after maturity at an interest rate reflecting market conditions.

9.3 INTERNATIONAL CASH MANAGEMENT

In this section we consider the issue of centralised versus decentralised cash management, which often faces companies with overseas branches or multi­national firms with subsidiaries in various countries. Centralised cash management implies that receipts and payments in various currencies are managed by a central body, normally in the company's head office. Decentral­ised cash management implies that these receipts and payments are managed locally by the branches or subsidiaries. The related issue of netting is also discussed.

Centralised cash management

Centralised cash management involves the transfer of a subsidiary's cash in excess of minimal operating requirements to a centrally managed account or a cash pool. In this case each subsidiary needs to hold locally only the minimum cash balance required for transaction purposes, whereas all precautionary balances are held by the parent firm or in the pool.

Most of the advantages of centralised cash management are associated with economies of scale. The first of these perceived advantages is netting. This operation involves the calculation of the overall corporate position in each currency by adding up the short and long positions of various branches and subsidiaries. Netting provides a natural hedge when there is a short position in one currency and an equivalent long position in the same currency.

Another advantage is currency diversification. Even if the combined posi­tion is not zero, centralised cash management may result in a combined posi­tion that is so diversified that the foreign exchange risk is sufficiently reduced, again removing the need to hedge individual positions. Specifically, if the combined exposure is well diversified, and if the exchange rates of these currencies against the base currency are not highly correlated, this will effec­tively provide a natural hedge. Alternatively, if exchange rates are positively correlated (as it is normally the case) then a natural hedge would be in place when long and short positions are taken on various currencies.

Pooling is another advantage of centralised cash management. By pooling cash balances in a centralised location, cash requirements by any branch or subsidiary anywhere can be met without having to keep balances denomi­nated in various currencies in every locality. The requirements of a subsidiary that is short of cash in a certain currency can be met from the central "pool of resources".

A centralised system has more advantages, including the following:

1. The firm is able to operate with a smaller amount of cash. Pools of excess liquidity are absorbed and eliminated.

2. By reducing total assets, profitability is enhanced and financing costs are reduced.

3. The headquarters staff, with knowledge of all corporate activity, can recog­nise problems and opportunities that an individual unit may not perceive.

4. All decisions are made using the overall corporate benefit as a criterion.

5. By increasing the volume of foreign exchange and other transactions done through the headquarters, firms encourage banks to provide better foreign exchange quotes and better service.

6. Greater expertise in cash and portfolio management exists if one group is responsible for these activities.

7. Less can be lost in the event of an expropriation or currency controls restricting the transfer of funds because the firm's total assets at risk in a foreign country can be reduced.

A drawback of centralised cash management is that it can create motiva­tional problems for local managers unless some adjustments are made to the way in which these managers are evaluated. One possible approach is to relieve local managers of profit responsibilities for their excess funds. An

alternative approach would be to present local managers with interest rates (for borrowing from or lending funds to the central pool) that reflect the opportunity cost of money to the parent firm. These are called internal interest rates.

Payment netting in international cash management

There are significant interaffiliate cash flows representing cross-border fund transfers. There are costs associated with these cash flows, including the cost of buying foreign exchange (the bid-offer spread), the opportunity cost of the time in transit (the time taken to receive the funds) and other costs such as cable charges. Minimising the volume of these cash flows leads to a reduction in these costs. The flows can be reduced via payment netting, which can be done on a bilateral or multilateral basis.

(9.1)

Figure 9.2 illustrates how bilateral netting works. In this case there are two companies, A and B, selling goods and services to each other. Without netting there are two payments: from A to B, X(A ® B),and fromBto A,X(B ® A). With netting, only one payment is made, which is equal to the net payment, N:

N = X(A ® B) - X(B ® A)

This payment will be made by A to B if X(A ® B) > X(B ® A), and vice versa.

Consider now multilateral netting involving four companies (A, B, C and D), as shown in Figure 9.3. In this case there is greater scope for reducing fund transfers by netting out each company's inflows against its outflows. To execute this function properly, a centre is needed to collect and record detailed information on intercompany accounts. As we can see from Figure 9.3, 12 payments have to be made without netting, and these are also shown in Table 9.1 (payments are recorded in columns and receipts are record in rows). Each company has to make three payments and receive three payments to and from other companies, as shown in Table 9.1.

If we calculate N as the difference between receipts and payments, we get

Without netting

With netting

X (A^ B) < X (B ^ A)

FIGURE 9.2 Bilateral netting.

Without netting

With netting

FIGURE 9.3 Multilateral netting.

TABLE 9.1 Multilateral payments involving four companies.

B

C

D

A

X(B ® A)

X(B ® C) X(B ® D)

X(A ® B) X(A ® C) X(A ® D)

X(C ® A) X(C ® B)

A

B C D

X(C ® D)

X(D ® A) X(D ® B) X(D ® C)

N(A) = X(B ® A) + X (C ® A) + X (D ® A)

-[X(A ® B) + X(A ® C) + X(A ® D)]

N(B) = X (A ® B) + X(C ® B) + X(D ® B) -[X(B ® A) + X(B ® C) + X(B ® D)]

N(C) = X(A ® C) + X(B ® C) + X(D ® C) -[X(C ® A) + X(C ® B) + X(C ® D)]

N(D) = X(A ® D) + X(B ® D) + X(C ® D)

-[X(D ® A) + X (D ® B) + X(D ® C)]

Since

N(A) + N(B) + N(C) + N(D) = 0 (9.6)

it follows that multilateral netting will result in three payments only, as shown in Figure 9.3. The circles representing the companies are blank because it could be any combination, depending on the actual payments and receipts. In general, if n companies are involved, the maximum number of payments without netting is n(n - 1). With netting, the number of payments reduces to n - 1. Figure 9.4 shows the effect of multilateral netting. If 36 companies are

Companies Without netting With netting

FIGURE 9.4 The number of payments as a function of the number of companies.

involved, the maximum number of payments without netting is 1260, which would be the case if every company makes a payment to every other company. With netting, the number declines to 35 payments only. Obviously, as the number of companies increases the advantage of multilateral netting becomes more pronounced.

Decentralised cash management

There are at least two reasons why decentralised cash management may be pref­erable. It is preferred when delays are expected in transferring funds to countries where the banking system is inefficient. Having the funds ready may be required to settle a transaction exposure with unknown timing. Decentralised cash management is also preferred when it is felt that local representation is necessary in order to maintain on-the-spot links with clients and banks. This is why this issue is not as much about the choice between centralised and decentralised cash management systems, but about determining the extent of centralisation and decentralisation.

If decentralised cash management is the case, what are the factors that determine where and in which currency cash balances are held? The following are some guidelines:

1. If it is anticipated that the funds received in a particular currency will be needed in the future, then transaction costs make it sensible to keep these funds in the same currency.

2. The same reasoning applies if there is no forward market in the underlying currency.

3. If political risk in one country is high, then funds should be kept in the home country rather than in the country in whose currency the funds are denominated.

4. Liquidity considerations make it sensible to keep funds in the currency in which they are most likely to be needed in the future.

5. Taxes are also important. In the presence of withholding taxes, funds should not be kept in countries with high tax rates.

Obviously, these factors may conflict with each other. Therefore a trade-off will be involved in the decision-making process.

9.4 THE EFFECTIVE FINANCING RATE AND THE EFFECTIVE RATE OF RETURN

In the absence of bid-offer spreads in interest rates, there is no difference between the lending and deposit rates in any currency, so the formula used to calculate the effective financing rate would be similar to that used to calculate the effective rate of return. We shall, therefore, consider the case without bid-offer spreads first.

No bid-offer spreads

Since there is no difference, let us just consider financing in currency y when the base currency is x and the exchange rate is expressed as S(x/y). The effec­tive financing rate in currency y depends on the nominal interest rate on y, iy, and the percentage change in the exchange rate, S.

Suppose that an amount, K, of currency y is borrowed at time t at a nominal interest rate iy. The base currency value of the amount borrowed, L_t, is given by

palgrave 1

palgrave 2

i 19

i 23

CHAPTER 3 44

Other Kinds of Arbitrage and Some Extensions 46

3.1 COMMODITY ARBITRAGE 46

^Py ,t+ 1^/Py ,t 55

3.2 ARBITRAGE UNDER THE GOLD STANDARD 61

3.3 ARBITRAGE BETWEEN EUROCURRENCY AND DOMESTIC INTEREST RATES 63

3.4 EUROCURRENCY-EUROBOND ARBITRAGE 74

3.5 ARBITRAGE BETWEEN CURRENCY FUTURES AND FORWARD CONTRACTS 52

3.6 REAL INTEREST ARBITRAGE 54

3.7 UNCOVERED ARBITRAGE WHEN THE CROSS RATES ARE STABLE 55

3.8 UNCOVERED INTEREST ARBITRAGE WHEN THE BASE CURRENCY IS PEGGED TO A BASKET 57

^ ^ 1=1 »j ^ j=1 and 57

E1= S ₀ - S j (3.40) 57

3.9 MISCONCEPTIONS ABOUT ARBITRAGE 83

CHAPTER 4 65

Hedging Exposure to Foreign Exchange Risk: The Basic Concepts 65

4.1 DEFINITION AND MEASUREMENT OF FOREIGN EXCHANGE RISK 65

4.2 VALUE AT RISK 69

4.3 DEFINITION AND MEASUREMENT OF EXPOSURE TO FOREIGN EXCHANGE RISK 74

4.4 TRANSACTION EXPOSURE 82

4.5 ECONOMIC AND OPERATING EXPOSURE 84

4.6 A FORMAL TREATMENT OF OPERATING EXPOSURE 95

dQ_py_ dPy Q 102

4.7 TRANSLATION EXPOSURE 123

Financial and Operational Hedging of Exposure to Foreign Exchange Risk 105

^Fb,t - ^Sb,t 123

^{p - K(F}a,t ^{- S}b,t+ 1 ⁾ 133

Measuring the Hedge Ratio 158

, ^s(DPu,t, ^DPA,t I^f t-1) ,_{t t} . 164

^h = ^ ^ r" = ^P(X 1,t , ^X 2 ,t ⁾ 164

^{s 2(D}P A,t^|f t-1 ⁾ 164

^DP u,t = t-1 + Z ^ai ^DP U,t-i +Z ^bi ^dPa ,t-i +^x 1,t ⁽⁶.³³⁾ 186

^DP A,t =^-bft-1 + Z ^ci ^DP U,t-i +Z ^d i ^DP A,t - i +^X 2 ,t ⁽⁶.³⁴⁾ 186

^s(DPU,t^{, D}PA,t I^f t-1^{, D}PU,t-i^{, D}PA,t-i⁾ 186

^s2 (^APA,t I^f t-1' ^APU,t-i ' ^APA,t-i ⁾ _{(6 35}) 186

I,t ' X 2,t ) / s(X i,t ) ^ 186

= P^(X 1't ' ^X 2 ,t ⁾ 186

_ P^(X 1,t ^{, X} 2 ,t^)s(X 1,t^)s(X 2 ,t^{) -2 (f} t-1^{1 A}P U,t-i^{, A}PA,t-i⁾ 187

^s2 (^X2 ,t ) + ^{b2 s 2} (f t-1^{1 A}PU,t-i^{, A}PA,t-i ) 187

Speculation in the Spot and Currency Derivative Markets 184

^Sb,t 198

^Sb,t ¹ + ^m 198

^Sb,t ¹ + ^E(mt+1⁾ 199

^{E( S}b,t+1 ⁾, S 200

if the position in x is available. If the funds have to be borrowed, the condition changes to 201

Speculation: Generating Buy and 209

Sell Signals 209

St = f (Xt) 257

where the vector of variables varies according to the underlying fundamental model. The current level of the exchange rate may deviate from the equilib­rium level because of the effect of random shocks that tend to have a tempo­rary effect. Hence the current level of the exchange rate may be represented by 258