INTERNATIONAL FINANCIAL

MANAGEMENT

CHAPTER 20:
SHORT-TERM
FINANCIING
Objectives
• Identify sources of short-term financing for MNCs.
• Explain how MNCs determine whether to use foreign financing.
• Illustrate the possible benefits of financing with a portfolio of
currencies.
Sources of Foreign Financing
Internal Short-Term Financing
• Before an multinational corporation (MNC) or subsidiary in need of funds
searches for outside funding, it should check other subsidiaries’ cash flow
positions to determine whether any internal funds are available.
• Internal Control over Funds - A multinational company (MNC) should have
an internal system to track the total amount of short-term borrowing of
all its subsidiaries. This allows them to identify which subsidiaries have
available cash in the same currency that another subsidiary needs.
Sources of Foreign Financing
External Short-Term Financing
• Short-Term Notes or Unsecured Debt Securities: Short-term notes
typically have a maturity of 1, 3, or 6 months, with interest rates based on
LIBOR.
• Commercial Paper (euro-commercial paper): If dealers issue commercial
paper for MNCs without the backing of an underwriting syndicate, the
issuer is not guaranteed a selling price. Maturities can be tailored to the
issuer’s preferences.
• Bank Loans: Direct loans from banks, which are often used to maintain
bank relation- ships, are another popular source of short-term funds for
MNCs.
• Multinational corporations have limited access to short-term funding
during a credit crisis.
Short-Term Financing with a Foreign Currency
• Multinational companies may borrow foreign currency sometimes to
match future cash flows.
• Interest Rate Comparison Between Currencies
▪ Developing countries tend to have higher inflation and lower savings
rates, leading to relatively higher interest rates compared to developed
countries.
Short-Term Financing with a Foreign Currency
Comparison of Short-Term Interest Rates
among Countries (as of October 2018)
Borrowing with a Foreign Currency
Motive for Financing with a Foreign Currency
• Even when an MNC or its subsidiary is not attempting to cover foreign net
receivables, it may still consider borrowing a foreign currency if the
interest rate on the currency is relatively low.
• By shaving just 1 percentage point off its financing rate, an MNC can save
$1 million in annual interest expense on debt of $100 million.
• Given the disparity in interest rates among countries, MNCs may naturally
consider financing with a foreign currency that has a low interest rate.
When doing so, they must weigh the potential cost savings against the
risk.
Borrowing with a Foreign Currency
Potential Costs Savings from Financing with a Foreign Currency
When an MNC borrows a currency that differs from its local currency, the
actual or “effective” financing rate will depend on
(1) the interest rate charged by the bank providing the loan and
(2) the movement in the borrowed currency’s value over the life of the
loan.
Specifically, the MNC’s effective financing rate (denoted r f ) can be derived
as follows:   S − S 
rf = (1 + i f ) 1 +  t +1
 − 1
  S 

where: rf = effective borrowing rate

S = spot exchange rate
if = the interest rate of the foreign currency over the loan period
Financing with a Foreign Currency
Potential Costs Savings from Financing with a Foreign Currency
  S − S 
rf = (1 + i f ) 1 +  t +1  − 1
  S 
where: rf = effective borrowing rate
S = spot exchange rate
if = the interest rate of the foreign currency over the loan period

St+1 −S
reflects % change in the spot exchange rate (ef), so the formula for
S
the effective borrowing rate can be rewritten as:

rf = 1 + if 1 + ef − 1
Financing with a Foreign Currency
Potential Costs Savings from Financing with a Foreign Currency
Example:
Dearborn Corporation borrows 1 million New Zealand dollars (NZD) for 1
year at an interest rate of 8%. It then converts the loan into U.S. dollars to
pay a materials supplier. The exchange rate is 0.5 USD, so it receives
500,000 USD.
• One year later, Dearborn repays the loan plus interest, which amounts to
80,000 NZD. The total NZD repayment is 1,080,000 NZD. At the time of
repayment, the exchange rate rises from 0.5 to 0.6 USD. Dearborn will
need 648,000 USD to repay the loan.
• What is the effective borrowing rate?
Financing with a Foreign Currency
Risk of Financing with a Foreign Currency
Although an MNC can benefit from financing in a currency with a low
interest rate that differs from the currency that it needs, the strategy could
backfire if the currency that is borrowed substantially appreciates over the
loan period.
Example:
If at the time of repayment, the exchange rate decreases from 0.5 to 0.45
USD, calculate the effective borrowing rate?
Financing with a Foreign Currency
Hedging the Foreign Currency Borrowed
To avoid exposure to exchange rate risk when borrowing a foreign currency,
an MNC could hedge its position by purchasing the borrowed currency
forward (for the time at which the loan is to be paid).
In this case, the MNC’s cost of financing will be affected by the percentage
difference between the spot rate at which the foreign currency was
converted to the local currency at the time it received the loan and the
forward rate that it pays to purchase the foreign currency when paying off
the loan.
The percentage difference of spot rate and forward rate of the loan reflects
the forward premium (p), which can be substituted for the percentage
change in the exchange rate (ef) in the equation representing the effective
financing rate:
rf = 1 + if 1 + p − 1
Financing with a Foreign Currency
Hedging the Foreign Currency Borrowed
• The percentage difference reflects the forward premium(p), which can be
susbstituted for the percentage change in the exchange rate (ef) in the
equation representing the effective financing rate:
rf = 1 + if 1 + p − 1
Under conditions of interest rate parity, a foreign currency’s forward
premium is determined by the differential between its interest rate and the
home interest rate:
1 + ih
p= −1
1 + if

1+ih
rf = 1 + if 1 + p − 1 = 1 + if 1+ − 1 − 1 = ih
1+if
• So, if interest rate parity exists, the attempt to finance with a low-interest-
rate currency and simultaneously hedge that position will result in an
effective financing rate that is similar to the local interest rate.
Financing with a Foreign Currency
Hedging the Foreign Currency Borrowed
• Cobra Co. needs to finance its operations in the U.S. for the next year and
wants to borrow Canadian dollars at the current interest rate of 3%
instead of borrowing U.S. dollars at the current rate of 8%.
• Since Cobra wants to minimize exchange rate risk, it considers borrowing
Canadian dollars for one year at 3% and simultaneously purchasing a one-
year forward contract in Canadian dollars to repay the loan in one year.
However, if interest rate parity holds, the one-year forward rate for the
Canadian dollar reflects the interest rate difference between the U.S. and
Canadian rates:
1 + ih 1,08
p= −1= − 1 = 4,85%
1 + if 1,03
Therefore, Cobra's effective borrowing rate under this strategy will be:
rf = 1 + if 1 + p − 1 = 1 + 0,03 1 + 0,0485 − 1 = 8%
Financing with a Foreign Currency
Reliance on the Forward Rate for Forecasts
• Although an MNC might not benefit from using the forward rate to hedge
when financing with a foreign currency, it might still use the forward rate
to forecast the future value of the foreign currency that it plans to borrow.
• If the prevailing one-year forward rate is used to forecast the spot rate
one year from now, then the prevailing forward rate premium represents
the forecast of the percentage change in the spot rate over the next year.
• The forward rate premium is determined by the differential in interest
rates between the two currencies. Thus, if interest rate parity exists, the
forward premium used to forecast the percentage change in the exchange
rate is determined by the differential in interest rates between the two
currencies. If the forward rate is an accurate estimator of the future spot
rate, then the foreign financing rate will be similar to the cost of
borrowing funds locally.
Financing with a Foreign Currency
Reliance on the Forward Rate for Forecasts
Financing with a Foreign Currency
Use of Probability Distributions to Enhance the Financing Decision
• Since forecasts are not always accurate, it can sometimes be helpful to
develop a probability distribution instead of relying on a single point
estimate.
• This allows for a comparison of the distribution with the known financial
ratios of the domestic currency to make financing decisions.
Example: Cobra Co. needs to finance its operations in the U.S., and its bank
offers two options: a loan in U.S. dollars at 8% or a loan in Canadian dollars
at 3%. Now, suppose the bank offers a third option: a loan in Japanese yen
at 4%. Cobra Co. wants to consider borrowing a portfolio of both Canadian
dollars and Japanese yen.
Assume that Cobra also forecasts the potential percentage change in the
spot rate for the Japanese yen during the loan period. Specifically, they
predict the yen will depreciate by 2% with a 70% probability, or the yen will
appreciate by 8% with a 30% probability.
Financing with a Portfolio of Currencies
POSSIBLE PERCENTAGE PROBABILITY OF COMPUTATION OF EFFECTIVE
CHANGE IN THE SPOT THAT PERCENTAGE FINANCING RATE BASED ON THAT
CURRENCY
RATE OVER THE LOAN CHANGE IN THE SPOT PERCENTAGE CHANGE IN THE
LIFE RATE OCCURING SPOT RATE
(1.03)[1 + (-0.01)] - 1 = 0.0197, or
Canada dollar -1% 60%
1.97%
(1.03)[1 + (0.10)] - 1 = 0.133, or
Canada dollar 10% 40%
13.3%

100%

(1.04)[1 + (-0.02)] - 1 = 0.0192 or

Japanese Yen -2% 70%
1.92%
(1.04)[1 + (0.08)] - 1 = 0.1232 or
Japanese Yen 8% 30%
12.32%,
100%
 Analysis of Financing with Two Foreign Currencies
(1) (2) (3) (4)
COMPUTATION OF EFFECTIVE
POSSIBLE JOINT EFFECTIVE FINANCING COMPUTATION OF JOINT FINANCING RATE OF PORTFOLIO
RATES PROBABILITY (50% OF TOTAL FUNDS BORROWED
IN EACH CURRENCY)
CANADA DOLLAR JAPANESE YEN
1.97% 1.92% (60%)*(70%) = 42% 0.5(1.97%) + 0.5(1.92%) = 1.945%
1.97 12.32 (60%)*(30%) = 18% 0.5(1.97%) + 0.5(12.32%) = 7.145%
13.3 1.92 (40%)*(70%) = 28% 0.5(13.3%) + 0.5(1.92%) = 7.61%
13.3 12.32 (40%)*(30%) = 12% 0.5(13.3%) + 0.5(12.32%) = 12.81%
100%
Financing with a Foreign Currency
• MNCs have different ways of forecasting exchange rates, which may lead
to different anticipated effective financing rates per currency, and perhaps
to different short-term financing decisions.
• Yet, even if all MNCs derived the same probability distribution of effective
financing rates, their final short-term financing decisions may vary
because of differences in their degree of risk aversion.
• Some MNCs might decide to borrow in the foreign currency portfolio,
given that the odds that such financing will have a lower cost than the U.S.
dollar loan are heavily in their favor.
• Other MNCs may be unwilling to take the chance (probability of 12%) that
both currencies will appreciate against the dollar and lead to a
substantially higher cost of funds than the U.S. dollar loan.
Harley Corp. needs to borrow for one year to finance a project in the
U.S. The borrowing rates are as follows:
USD 10%
Canada 6%
Japan 5%

The percentage change in the spot exchange rate for the Canadian
dollar and the Japanese yen over the next year is as follows:
Canada Dollar Japanese Yen
Probability % change in Probability % change in
exchange rate exchange rate
10% 5% 20% 6%
90% 2% 80% 1%

If Harley Corp. borrows a portfolio with 50% in Canadian dollars and

50% in Japanese yen, determine the probability distribution of the
effective borrowing rate for this portfolio. What is the probability that
Harley will face a higher effective borrowing rate with this portfolio
compared to borrowing in U.S. dollars?
Janus Corporation has recently issued a bond worth 200 million USD
with a fixed interest rate of 10% for 3 years. However, the company is
also considering switching to a floating interest rate for its debt. Under
this approach, the company would enter into an interest rate swap
agreement, exchanging floating-rate payments LIBOR + 1% for a fixed
10% interest rate. Janus expects LIBOR to be 9% at the end of the first
year, 8.5% at the end of the second year, and 7% at the end of the third
year. Determine the interest rate Janus will likely pay on its debt when
using the interest rate swap.

Year LIBOR Rate LIBOR + 1%

1 9% 10%
2 8.5% 9.5%
3 7% 8%