Financing Short Term

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Chapter Objectives

To explain why MNCs considerforeign financing;

To explain how MNCs determine whetherto 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 securitieswith typical maturities of 1, 3 or 6 months.

They are underwritten by commercialbanks.

MNCs may also issue Euro-commercial

papers to obtain short-term financing. MNCs utilize direct Eurobank loans to

maintain a relationship with the banks too.


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Internal Financing by MNCs

Before an MNCs parent or subsidiarysearches for outside funding, it should

determine if any internal funds areavailable.

Parents of MNCs may also raise funds by

increasing their markups on the suppliesthat they send to their subsidiaries.


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Why MNCs Consider

Foreign Financing

An MNC may finance in a foreign currencyto offset a net receivables position in that

foreign currency.

An MNC may also consider borrowingforeign currencies when the interest rates

on such currencies are attractive, so as toreduce the costs of financing.


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Determining the

Effective 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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Effective financing rate, rf

=

{(1+if) v St+1} {1 v St}

=(1+if)

St+1

1{1 v St} Stwhere if = the interest rate on the loan

St = beginning spot rateSt+1 = ending spot rate

Determining the

Effective Financing Rate

The effective rate can be rewritten as

rf = (1+if) (1+ef) 1

where ef = the % ( in the spot rate


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Criteria Considered for

Foreign Financing

There are various criteria an MNC mustconsider in its financing decision,

including interest rate parity,

the forward rate as a forecast, and

exchange rate forecasts.


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Foreign Financing

Interest Rate Parity (IRP)

IfIRP holds, foreign financing with asimultaneous hedge of that position in the

forward market will result in financing

costs similar to those for domestic

financing.


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The Forward Rate as a Forecast

If the forward rate is an unbiased predictorof the future spot rate, then the effective

financing rate of a foreign loan will on

average be equal to the domestic

financing rate.


Foreign Financing


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Exchange Rate Forecasts

Firms may use exchange rate forecasts toforecast 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.


Foreign Financing


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Financing with a

Portfolio of Currencies

While foreign financing can result insignificantly lower financing costs, the

variance in the costs is higher.

MNCs may be able to achieve lowerfinancing costs without excessive risk by

financing with a portfolio of currencies.


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Financing with a


If the chosen currencies are not highlypositively correlated, they will not be likely

to experience a high level of appreciationsimultaneously.

Thus, the chances that the portfolios

effective financing rate will exceed thedomestic financing rate are reduced.


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A firm that repeatedly finances in acurrency portfolio will normally prefer to

compose a financing package thatexhibits a somewhat predictable effective

financing rate on a periodic basis.

When comparing different financingpackages, the variance can be used tomeasure how volatile a portfolios

effective financing rate is.

Financing with a



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For a two-currency portfolio,

E(rP

) =wA

E(rA

) + wB

E(rB

)

where rP = the effective financing rate of theportfolio

rX = the effective financing rate of

currency XwX = the % of total funds financed from

currency X

Financing with a



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V

ar(rP) =wA2

WA2

+ wB2

WB2

+ 2wAwBWAWBCORR

AB

WX2 = the variance of currency Xseffective financing rate

CORRAB = the correlation coefficient of the two

currencies effective finance rates

Financing with a


For a two-currency portfolio,


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Impact of Short-Term Financing Decisionson an MNCs Value

? A

!

n

tt

j

tjtj

k1=

1

,,

1

ERECFE

=V l

E (CFj,t) = expected cash flows in currencyjto be received

by the U.S. parent at the end of period t

E (ERj,t) = expected exchange rate at which currencyjcan

be converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Expenses Incurred fromShort-Term Financing


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Sources of Short-Term Financing Euronotes

Euro-Commercial Paper Eurobank Loans

Internal Financing by MNCs

Why MNCs Consider Foreign Financing Foreign Financing to Offset Foreign

Receivables

Foreign Financing to Reduce Costs

Chapter Review


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Chapter Review

Determining the Effective Financing Rate

Criteria Considered for Foreign Financing Interest Rate Parity

The Forward Rate as a Forecast

Exchange Rate Forecasts


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Chapter Review

Financing with a Portfolio of Currencies Portfolio Diversification Effects

Repeated Financing with a CurrencyPortfolio

Impact of Short-Term Financing Decisions

on an MNCsV

alue

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Financing Short Term