Short-Term FinancingShort-Term Financing

2020 Chapter Chapter

South-Western/Thomson Learning © 2006 Slides by Yee-Tien (Ted) Fu

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Chapter Objectives

To explain why MNCs consider foreign financing;

To explain how MNCs determine whether to use foreign financing; and

To illustrate the possible benefits of financing with a portfolio of currencies.

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Sources of Short-Term Financing

• Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6 months. They are underwritten by commercial banks.

• MNCs may also issue Euro-commercial papers to obtain short-term financing.

• MNCs utilize direct Eurobank loans to maintain a relationship with Eurobanks too.

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Internal Financing by MNCs

• Before an MNC’s parent or subsidiary searches for outside funding, it should determine if any internal funds are available.

• Parents of MNCs may also raise funds by increasing their markups on the supplies that they send to their subsidiaries.

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Why MNCs ConsiderForeign Financing

• An MNC may finance in a foreign currency to offset a net receivables position in that foreign currency.

• An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce financing costs.

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Short-Term Interest Ratesas of February 2004

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Determining theEffective Financing Rate

The actual cost of financing depends on

the interest rate on the loan, and

the movement in the value of the borrowed currency over the life of the loan.

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2. Converts to $500,000

Exchange rate = $0.50/NZ$

What is the effective financing rate?

3. Has to pay back

NZ$1,080,000

1 year later

1. Borrows NZ$1,000,000

at 8.00%for 1 year

At time t

4. Converts to $648,000

Exchange rate = $0.60/NZ$

Determining theEffective Financing Rate

$648k – $500k = 29.6% !

$500k

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• The effective financing rate, rf , can be written as:

rf = (1 + if )(1 + ef ) – 1

where if = the foreign currency interest rate

ef = the % in the foreign currency’sspot rate

= St+1 – S S

Determining theEffective Financing Rate

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Criteria Considered forForeign Financing

• There are various criteria an MNC must consider in its financing decision, including¤ interest rate parity,¤ the forward rate as a forecast, and¤ exchange rate forecasts.

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Criteria Considered forForeign Financing

Interest Rate Parity (IRP)

• If IRP holds, foreign financing with a simultaneous hedge of that position in the forward market will result in financing costs that are similar to those for domestic financing.

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Implications of IRP for Financing

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The Forward Rate as a Forecast

• If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign loan will on average be equal to the domestic financing rate.

Criteria Considered forForeign Financing

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Exchange Rate Forecasts

• Firms may use exchange rate forecasts to forecast the effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates.

• Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates.

Criteria Considered forForeign Financing

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Probability Distribution ofEffective Financing Rate

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Probability Distribution ofEffective Financing Rate

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Actual ResultsFrom Foreign Financing

• The fact that some firms utilize foreign financing suggests that they believe reduced financing costs can be achieved.

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Financing with Swiss Francs versus Dollars

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Financing with a Portfolio of Currencies

• While foreign financing can result in significantly lower financing costs, the variance in costs over time is higher.

• MNCs may be able to achieve lower financing costs without excessive risk by financing with a portfolio of currencies.

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Probability Distribution ofEffective Financing Rates

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Analysis of Financing withTwo Foreign Currencies

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Probability Distribution of thePortfolio’s Effective Financing Rate

Financing with the portfolio has only a 5% chance of being more costly than domestic financing. This result is also more favorable than those of the individual foreign currencies.

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PortfolioDiversification Effects

• If the chosen currencies are not highly positively correlated, they will not be likely to experience a high level of appreciation simultaneously.

• Thus, the chance that the portfolio’s effective financing rate will exceed the domestic financing rate is reduced.

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• A firm that repeatedly finances with a currency portfolio will normally prefer to compose a financing package that exhibits a somewhat predictable effective financing rate on a periodic basis.

• When comparing different financing packages, the variance can be used to measure how volatile a portfolio’s effective financing rate is.

Repeated Financing with a Currency Portfolio

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For a two-currency portfolio,

(rP) = wA(rA) + wB(rB)

where rP = the effective financing rate of the portfolio

rX = the effective financing rate of currency X

wX = the % of total funds financed from currency X

Repeated Financing with a Currency Portfolio

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Var(rP) = wA2A

2 + wB2B

2 + 2wAwBABCORRAB

X2 = the variance of

currency X’s effective financing rate

CORRAB = the correlation coefficient of the two currencies’ effective finance rates

For a two-currency portfolio,

Repeated Financing with a Currency Portfolio