Currency Spot Exchange Rate
Forecasted Annual
Percentage Change
in Exchange Rates
Australian dollar $.70 –4%
Canadian dollar .80 –2
New Zealand dollar .60 +3
Japanese yen .008 0
1. Determine the investment portfolio composition for Kent’s eastern branch that would maximize the
expected effective yield, while satisfying the restriction imposed by the parent.
When accounting for the interest rate and forecasted exchange rates, the expected effective yields are
listed below:
Currency
Expected Effective
Yield on Investment
U.S. dollar 6.00%
Australian dollar 6.56
Canadian dollar 4.86
New Zealand dollar 12.27
Japanese yen 8.00
ANSWER:
Given these expected effective yields, the investment should be allocated as follows:
$5 million invested in New Zealand dollars
2. What is the expected effective yield of the investment portfolio?
3. Based on the expected effective yield for the portfolio and the initial investment amount of $15
million, determine the annual interest to be earned on the portfolio.
4. Determine the financing portfolio composition for Kent’s western branch that would minimize the
expected effective financing rate, while satisfying the restriction imposed by the parent.
When accounting for the interest rate and forecasted exchange rate, the expected effective financing
rates are listed below:
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International Cash Management 2
Currency
Expected Effective
Financing Rate
U.S. dollar 9.00%
Australian dollar 9.44
Canadian dollar 7.80
New Zealand dollar 15.36
Japanese yen 11.00
ANSWER:
5. What is the expected effective financing rate of the total amount of funds borrowed?
6. Based on the expected effective financing rate for the portfolio and the total amount of $15 million
borrowed, determine the expected loan repayment amount beyond the principal borrowed.
7. When the expected interest received by the eastern branch and paid by the western branch of Kent
Company are consolidated, what is the net amount of interest received?
ANSWER:
8. If the eastern branch and western branch worked together, the eastern branch could loan its $15
million to the western branch. Nevertheless, one could argue that the branches could not have taken
advantage of interest rate differentials or expected exchange rate effects among currencies. Given the
data provided in this example, would you have recommended that the two branches make their short-
term investment and financing decisions independently, or should the eastern branch lend its excess
cash to the western branch? Explain.
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International Cash Management 3
BACKGROUND
One of the best methods of learning broad concepts in this text is to put yourself in the place of an MNC
manager or board member, and apply the concepts to make financial decisions. Board members do not
normally make the decisions that are discussed here, but must have the conceptual skills to monitor the
policies that are implemented by the MNC’s managers. Thus, they must frequently ask themselves what
they would do if they were making the managerial decisions or setting corporate polices.
Consider the following business that you could easily create: a business that teaches individuals in a non-
U.S. country to speak English. While this business is very basic, it still requires the same type of decisions
faced by large MNCs. Assume that you initially establish this business in Mexico.
Details of Your Business. You live in the U.S. You invested $60,000 to establish a business of a language
school called EE (Escuela de Engles) in Mexico City, Mexico. You hire local individuals in Mexico who
can speak English and train others how to speak English. You have a small subsidiary in Mexico, which
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International Cash Management 4
has an office and an attached classroom that you lease. Clients can come to your subsidiary for a 1-month
structured course in English, taught by your employees. You advertise in the local newspapers to promote
the teaching services offered by your business.
You also serve some individuals from Mexico who have taken English classes and want to come to the
U.S. for a one-week intense course in which they can improve and practice their English and practice it.
All revenue and expenses associated with your business are denominated in Mexican pesos. Most of the
profits from the business in Mexico are sent to you by your subsidiary at the end of each month. While
your expenses are somewhat stable, your revenue varies with the number of clients who sign up for the
English-speaking courses in Mexico.
You only need to know this background so that you can answer the related questions that are asked about
your business throughout the term. Answer each question as if you were serving on the board of your
business or as a manager of the business. The questions in the early chapters force you to assess the firm’s
opportunities and exposure, while the later chapters force you to offer your input on potential strategies
that your business may pursue.
Chapter 1
a. Discuss the corporate control of your business. Explain why your business in Mexico is exposed
to agency problems.
b. How would you attempt to monitor the ongoing operations of the business?
c. Explain how you might be able to use a compensation plan that limits the potential agency
problems?
d. Assume that you have been approached by a competitor in Mexico to engage in a joint venture.
The competitor would offer the classroom facilities (so that you would not need to rent classroom
facilities), while your employees would provide the teaching. You would split the profits with this
business. Discuss how your potential return and your risk would change if you pursue the joint
venture.
e. Explain the conditions that would cause your business to be adversely affected by exchange rate
movements.
f. Explain how your business could be adversely affected by political risk.
ANSWER:
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International Cash Management 5
Chapter 2
Your business provides DVDs for free to customers who pay for the English courses that you offer in
Mexico. You consider the idea of mass production of the DVDs in the U.S., so that you can sell (export)
them to distributors or to retail stores throughout Mexico. You would price the DVDs in dollars when
exporting them. The DVDs are not as effective without the teaching, but can be useful to individuals who
want to learn the basics of the English language.
a. If you pursue this idea, explain how the factors that affect international trade flows (identified in
Chapter 2) could affect the Mexican demand for your DVDs. Which of these factors would likely
have the largest impact on the Mexican demand for your DVDs? What other factors would affect
the Mexican demand for the DVDs?
b. If you believe the Mexican government would impose a tariff on the DVDs exported to Mexico,
how could you still execute this business idea at a relatively low cost while avoiding the tariff?
Describe any disadvantages of this idea that would avoid the tariff.
ANSWER:
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International Cash Management 6
Chapter 3
Assuming that the business in Mexico grows, explain how financial markets could help to finance the
growth of the business.
ANSWER:
Chapter 4
Given the factors that affect the value of a foreign currency, describe the type of economic or other
conditions in Mexico that could cause the Mexican peso to weaken, and therefore to adversely affect your
business.
ANSWER:
Chapter 5
Explain how currency futures could be used to hedge your business in Mexico. Explain how currency
options could be used to hedge your business in Mexico.
ANSWER:
You could purchase Mexican peso put options to hedge the expected monthly profits in Mexican pesos
that would have to be converted into dollars.
Chapter 6
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International Cash Management 7
a. Explain how your business would likely be affected (at least in the short run) if the central bank
of Mexico intervened in the foreign exchange market by exchanging Mexican pesos for dollars in
the foreign exchange market.
b. Explain how your business would likely be affected if the central bank of Mexico used indirect
intervention by lowering Mexican interest rates (assume inflationary expectations have not
changed).
ANSWER:
Chapter 7
Mexican interest rates are normally substantially higher than U.S. interest rates.
a. What does this imply about the forward premium or discount of the Mexican peso?
b. What does this imply about your business using the forward or futures contracts to hedge your
periodic profits in pesos that must be converted into dollars?
c. Do you think you would frequently hedge your exposure to Mexican pesos? Explain your answer.
ANSWER:
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International Cash Management 8
Chapter 8
Mexican interest rates are normally substantially higher than U.S. interest rates.
a. What does this imply about the inflation differential (Mexico inflation minus U.S. inflation),
assuming that the peso interest rate is the same in both countries? Does this imply that the
Mexican peso will appreciate or depreciate? Explain.
b. It may be argued that the high Mexican interest rate should entice U.S. investors to invest in
Mexican money market securities, which could cause the peso to appreciate. Reconcile this
theory with your answer (a). If you believe that the high Mexican interest rate does not entice
U.S. investors, explain why.
c. Assume that the difference between Mexican and U.S. interest rates is typically attributed to a
difference in expected inflation in the two countries. Also assume that purchasing power parity
holds. Do you think that your business cash flows would be adversely affected? In reality,
purchasing power parity does not hold consistently. Assume that the inflation differential (Mexico
inflation minus U.S. inflation) is not fully offset by the exchange rate movement of the peso.
Would this benefit or hurt your business? Now assume that the inflation differential is more than
offset by the exchange rate movement of the peso. Would this benefit or hurt your business?
d. Assume that the nominal interest rate in Mexico is presently much higher than the interest rate in
the U.S., which is due to a high rate of expected inflation in Mexico. You consider implementing
a marketing campaign in which you would hire a local firm to promote your business, but you
would have to borrow funds to finance this campaign. A consultant advises you to delay the
marketing campaign for a year, so that you can capitalize on the high nominal interest rate in
Mexico. He suggests that you retain the profits that you would normally have remitted to the
U.S., and deposit them in a Mexican bank. The Mexican peso cash flows that your business
deposits will grow at a high rate of interest over the year. Should you follow the consultant’s
advice?
ANSWER:
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International Cash Management 9
Chapter 9
a. Mexican interest rates are normally substantially higher than U.S. interest rates. What does this
imply about the forward rate as a forecast of the future spot rate?
b. Does the forward rate reflect a forecast of appreciation or depreciation of the Mexican peso?
Explain how the degree of the expected change implied by the forward rate forecast is tied to the
interest rate differential.
c. Do you think that today’s forward rate or today’s spot rate of the peso would be a better forecast
of the future spot rate of the peso?
ANSWER:
Chapter 10
Recall that your Mexican business invoices in Mexican pesos.
a. You are already aware that a decline in the value of the peso could reduce your dollar cash flows.
Yet, according to purchasing power parity, a weak peso should only occur in response to a high
level of Mexican inflation, and such high inflation should increase your profits. If this theory
holds precisely, your cash flows would not really be exposed. Should you be concerned about
your exposure, or not? Explain.
b. If you shift your invoicing policy to be only in dollars, how will your transaction exposure be
affected?
c. Why might the demand for your business change if you shift your invoice policy? What are the
implications for economic exposure?
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International Cash Management 10
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