Chapter 20
Short-Term Financing
Lecture Outline
Sources of Short-Term Financing
Internal Financing by MNCs
Why MNCs Consider Foreign Financing
Foreign Financing to Offset Foreign Currency Inflows
Foreign Financing to Reduce Costs
Determining the Effective Financing Rate
Criteria Considered for Foreign Financing
Interest Rate Parity
The Forward Rate as a Forecast
Exchange Rate Forecasts
Actual Results from Foreign Financing
Financing with a Portfolio of Currencies
Portfolio Diversification Effects
Repeated Financing with a Currency Portfolio
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Chapter 20: Short-Term Financing
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Chapter Theme
This chapter explains short-term liability management of MNCs. From this chapter, students should
learn that correct financing decisions can reduce the firm’s costs. While foreign financing costs cannot
usually be perfectly forecasted, firms should evaluate the probability of reducing costs through foreign
financing.
Topics to Stimulate Class Discussion
1. If a firm consistently exports to a country with low interest rates and needs to consistently borrow
funds, explain how it could coordinate its invoicing and financing to reduce its financing costs.
2. What is the risk of borrowing a low interest rate currency?
3. Assume that foreign currencies X, Y, and Z are highly correlated. If a firm diversifies its financing
among these three currencies, will it substantially reduce its exchange rate exposure (as opposed to
borrowing all funds from one of these foreign currencies)? Explain.
POINT/COUNTER-POINT:
Do MNCs Increase Their Risk When Borrowing Foreign Currencies?
POINT: Yes. MNCs should borrow the currency that matches their cash inflows. If they borrow a
foreign currency to finance business in a different currency, they are essentially speculating on the
future exchange rate movements. The results of their strategy are uncertain, which represents risk to
the MNC and its shareholders.
COUNTER-POINT: No. If MNCs expect that they can reduce the effective financing rate by
borrowing a foreign currency, they should consider borrowing that currency. This enables them to
achieve lower costs, and improves their ability to compete. If they take the most conservative approach
by borrowing whatever currency matches their inflows, they may incur higher costs, and have a
greater chance of failure.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you
support? Offer your own opinion on this issue.
ANSWER: If MNCs borrow in a low interest rate currency that is not matched with their inflow
currencies, they may be able to reduce their effective financing rate. However, they increase their
exposure to exchange rate risk. Their decision is based on a tradeoff of expected reduction in financing
expenses versus the risk that the currency their borrow appreciates against their inflow currencies.
Answers to End of Chapter Questions
1. Financing From Subsidiaries. Explain why an MNC parent would consider financing from its
subsidiaries.
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International Financial Management
ANSWER: A parent may obtain funds at a lower cost from its subsidiaries than from a bank, since
a bank will maintain a spread between what it offers depositors and charges on loans.
2. Foreign Financing.
a. Explain how a firm’s degree of risk aversion enters into its decision of whether to finance in a
foreign currency or a local currency.
ANSWER: A very risk-averse firm may prefer to borrow domestically since it knows with
certainty the cost of financing in advance. Yet, other firms may feel that the potential cost savings
from foreign financing outweighs the risk (uncertainty); this may motivate them to consider
financing in a foreign currency.
b. Discuss the use of specifying a break-even point when financing in a foreign currency.
ANSWER: A break-even exchange rate percentage change will indicate to a firm the amount by
which a low interest rate currency must appreciate to make its financing cost the same as a
domestic currency.
3. Probability Distribution.
a. Discuss the development of a probability distribution of effective financing rates when
financing in a foreign currency. How is this distribution developed?
ANSWER: First, a probability distribution of exchange rate changes is created. Using this along
with the foreign currency’s quoted interest rate, the probability distribution of effective financing
rates can be developed.
b. Once the probability distribution of effective financing rates from financing in a foreign
currency is developed, how can this distribution be used in deciding whether to finance in the
foreign currency or the home currency?
ANSWER: A distribution of effective financing rates can be used to determine the probability that
foreign financing will be more costly than domestic financing. Then, the final decision will
depend on the firm’s degree of risk aversion.
4. Financing and Exchange Rate Risk. How can a U.S. firm finance in euros and not necessarily be
exposed to exchange rate risk?
ANSWER: If it has inflows in euros, it could use a portion of the inflows to pay its financing
expenses.
5. Short-term Financing Analysis. Assume that Tulsa Inc. needs $3 million for a one-year period.
Within one year, it will generate enough U.S. dollars to pay off the loan. It is considering three
options: (1) borrowing U.S. dollars at an interest rate of 6%, (2) borrowing Japanese yen at an
interest rate of 3%, or (3) borrowing Canadian dollars at an interest rate of 4%. Tulsa Inc. expects
that the Japanese yen will appreciate by 1% over the next year and that the Canadian dollar will
appreciate by 3%. What is the expected “effective” financing rate for each of the three options?
Which option appears to be most feasible? Why might Tulsa Inc. not necessarily choose the option
reflecting the lowest effective financing rate?
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ANSWER:
Currency
Dollars
Japanese yen
Canadian dollars
Interest
Rate
6%
3%
4%
Expected Percentage
Change in Currency
—
+1%
+3%
Expected
Effective
Financing Rate
6.00%
4.03%
7.12%
ANSWER: The Japanese yen option appears to be the most feasible option. Yet, the exchange rate
percentage change is uncertain, which makes the effective financing rate uncertain. Thus, Tulsa
Inc. will not necessarily choose this option.
6. Effective Financing Rate. How is it possible for a firm to incur a negative effective financing
rate?
ANSWER: If the currency borrowed substantially depreciates against the firm’s home currency
(by at least the interest rate percentage as a rough approximation), the effective financing rate will
be negative.
7. IRP Application to Short-term Financing. If interest rate parity does not hold, what strategy
should Connecticut Co. consider when it needs short-term financing?
a. Assume that Connecticut Co. needs dollars. It borrows euros at a lower interest rate than that
for dollars. If interest rate parity exists and if the forward rate of the euro is a reliable predictor
of the future spot rate, what does this suggest about the feasibility of such a strategy?
ANSWER: The firm could consider borrowing a foreign currency and purchasing the currency
forward to lock in its financing cost.
If the forward rate is a reliable predictor, the effective financing rate on the foreign financing
would be the same as the domestic financing. So, foreign financing is not feasible.
b. If Connecticut Co. expects the spot rate to be a more reliable predictor of the future spot rate,
what does this suggest about the feasibility of such a strategy?
ANSWER: If the expected spot is more reliable, the foreign financing should be less costly than
domestic financing, because this implies that the expected percentage change in the euro’s value is
zero, so that the interest rate on euros represents the expected effective financing rate when
financing with euros.
8. Break-even Financing. Akron Co. needs dollars. Assume that the local one-year loan rate is 15%,
while a one-year loan rate on euros is 7%. By how much must the euro appreciate to cause the
loan in euros to be more costly than a U.S.-dollar loan?
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International Financial Management
ANSWER:
(1.15) – 1 = 7.477%
(1.07)
The euro must appreciate by about 7.477% over the year in order to make the loan in euros as
costly as a U.S. dollar loan.
9. IRP Application to Short-term Financing. Assume that interest rate parity exists. If a firm
believes that the forward rate is an unbiased predictor of the future spot rate, will it expect to
achieve lower financing costs by consistently borrowing a foreign currency with a low interest
rate?
ANSWER: No, because a foreign currency with a relatively low interest rate exhibits a forward
premium that offsets the interest rate differential. Thus, if the forward rate is the expected future
spot rate, this implies that the foreign currency will appreciate over the financing period by an
amount that will offset the interest rate advantage.
10. Effective Financing Rate. Boca, Inc., needs $4 million for one year. It currently has no business
in Japan but plans to borrow Japanese yen from a Japanese bank, because the Japanese interest
rate is three percentage points lower than the U.S. rate. Assume that interest rate parity exists; also
assume that Boca believes that the one-year forward rate of the Japanese yen will exceed the
future spot rate one year from now. Will the expected effective financing rate be higher, lower, or
the same as financing with dollars? Explain.
ANSWER: Since the forward rate is expected to overestimate the future spot rate, this implies that
the yen will not appreciate to the level that would fully offset the interest rate differential.
Therefore, the expected effective financing rate of the yen is lower than the U.S. financing rate.
11. IRP Application to Short-term Financing. Assume that the U.S. interest rate is 7 percent and the
euro’s interest rate is 4 percent. Assume that the euro’s forward rate has a premium of 4 percent.
Determine whether the following statement is true: “Interest rate parity does not hold; therefore,
U.S. firms could lock in a lower financing cost by borrowing euros and purchasing euros forward
for one year.” Explain your answer.
ANSWER: No. While interest rate parity does not hold, the financing with euros would result in
an effective financing rate of:
(1 + 4%)(1 + 4%) – 1 = 8.16%
This exceeds the U.S. rate. For a U.S. firm to be able to lock in a lower financing cost by
borrowing euros and purchasing euros forward, the premium on the forward rate of the euro would
have to be less than the interest rate differential.
12. Break-even Financing. Orlando, Inc., is a U.S.-based MNC with a subsidiary in Mexico. Its
Mexican subsidiary needs a one-year loan of 10 million pesos for operating expenses. Since the
Mexican interest rate is 70 percent, Orlando is considering borrowing dollars, which it would
convert to pesos to cover the operating expenses. By how much would the dollar have to
appreciate against the peso to cause such a strategy to backfire? (The one-year U.S. interest rate is
9%.)
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ANSWER:
1 + 70%
-1 = 55.96%
1 + 9%
The dollar would have to appreciate by more than 55.96 percent for the strategy to backfire.
13. Financing Since the Asian Crisis. Bradenton, Inc., has a foreign subsidiary in Asia that
commonly obtained short-term financing from local banks prior to the Asian crisis. Explain why
the firm may not be able to easily obtain funds from the local banks since the crisis.
ANSWER: The foreign subsidiary may find that the local banks do not have adequate funding
from depositors any more to provide credit. Alternatively, the banks may be concerned about the
credit risk given the large number of defaults by firms.
14. Effects of September 11. Homewood Co. commonly finances some of its U.S. expansion by
borrowing foreign currencies (such as Japanese yen) that have low interest rates. Describe how the
potential return and risk of this strategy may have changed after the September 11, 2001 terrorist
attack on the U.S.
ANSWER: The attack on the U.S. caused short-term interest rates in the U.S. to decline, which
reduced the cost of borrowing dollars. Thus, the appeal of borrowing funds denominated in
foreign currencies was reduced. Furthermore, the decline in U.S. interest rates and the weak stock
prices in the U.S. caused a decline in capital flows to the U.S. and could possibly cause a decline
in the dollar. If the dollar weakens, the cost of financing in the foreign securities would increase.
15. Probability Distribution of Financing Costs. Missoula, Inc., decides to borrow Japanese yen for
one year. The interest rate on the borrowed yen is 8 percent. Missoula has developed the following
probability distribution for the yen’s degree of fluctuation against the dollar:
Possible Degree of Fluctuation
of Yen Against the Dollar
–4%
–1%
0%
3%
Percentage
Probability
20%
30%
10%
40%
Given this information, what is the expected value of the effective financing rate of the Japanese
yen from the U.S. corporation’s perspective?
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International Financial Management
ANSWER:
Japanese
Interest Rate
8%
8%
8%
8%
Possible %
Change in
Yen Value
–4%
–1%
0%
3%
Effective
Financing Rate
Based on
That Change
3.68%
6.92%
8.00%
11.24%
Probability
20%
30%
10%
40%
Computation of
Expected Value
.736%
2.076%
.800%
4.496%
8.108%
Expected value = 8.108%
16. Analysis of Short-term Financing. Jacksonville Corp. is a U.S.-based firm that needs $600,000.
It has no business in Japan but is considering one-year financing with Japanese yen, because the
annual interest rate would be 5 percent versus 9 percent in the United States. Assume that interest
rate parity exists.
a. Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing yen
one year forward to avoid exchange rate risk? Explain.
ANSWER: If Jacksonville borrows yen and simultaneously purchases yen one year forward, it
will pay a forward premium that will offset the interest rate differential (given that interest rate
parity exists). Based on interest rate parity, the forward premium is about 3.8%. The effective
financing rate would be:
(1 + 5%)(1 + 3.8%) – 1 = about 9%
b. Assume that Jacksonville does not cover its exposure and uses the forward rate to forecast the
future spot rate. Determine the expected effective financing rate. Should Jacksonville finance
with Japanese yen? Explain.
ANSWER: If it does not cover the exposure but uses the forward rate as a forecast, the expected
percentage change in the Japanese yen’s value is about 3.8 percent. Thus, the expected effective
financing rate is 9%. Jacksonville should therefore finance with dollars rather than Japanese yen,
since the expected cost of financing with dollars is not higher.
c. Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will
appreciate by either 5 percent, 3 percent, or 2 percent, and with equal probability of each
occurrence. Use this information to determine the probability distribution of the effective
financing rate. Should Jacksonville finance with Japanese yen? Explain.
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ANSWER:
Possible %
Change in Spot
Rate of JY
5%
3%
2%
Effective Financing
Rate of JY if that
Percentage Change Occurs
(1.05)(1.05) – 1 = 10.25%
(1.05)(1.03) – 1 = 8.15
(1.05)(1.02) – 1 = 7.10
Probability
33.3%
33.3%
33.3%
Given the probability, there is about a 67 percent chance that financing with Japanese yen will be
less costly than financing with dollars. The choice of financing with yen or dollars in this case is
dependent on Jacksonville’s degree of risk aversion.
17. Financing With a Portfolio. Pepperdine, Inc., considers obtaining 40 percent of its one-year
financing in Canadian dollars and 60 percent in Japanese yen. The forecasts of appreciation in the
Canadian dollar and Japanese yen for the next year are as follows:
Currency
Canadian dollar
Canadian dollar
Japanese yen
Japanese yen
Possible Percentage
Change in the Spot
Rate Over the Loan Life
4%
7
6
9
Probability
of that Percentage
Change in the
Spot Rate Occurring
70%
30
50
50
The interest rate on the Canadian dollar is 9 percent, and the interest rate on the Japanese yen is 7
percent. Develop the possible effective financing rates of the overall portfolio and the probability
of each possibility based on the use of joint probabilities.
ANSWER:
Currency
Canadian dollar
Canadian dollar
Japanese yen
Japanese yen
Possible Joint
Effective
Financing Rate
JY
C$
13.36% 13.42%
13.36
16.63
16.63
13.42
16.63
16.63
Interest
Rate
9%
9
7
7
Possible
% Change
4%
7
6
9
Joint
Probability
(70%)(50%) = 35%
(70%)(50%) = 35%
(30%)(50%) = 15%
(30%)(50%) = 15%
Effective
Financing
Rate Based on
that Change
13.36%
16.63
13.42
16.63
Probability
70%
30
50
50
Effective Financing
Rate of Portfolio
.4(13.36%) + .6(13.42%) = 13.396%
.4(13.36%) + .6(16.63%) = 15.322%
.4(16.63%) + .6(13.42%) = 14.704%
.4(16.63%) + .6(16.63%) = 16.630%
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International Financial Management
Thus, there is a 35% probability that the portfolio’s effective financing rate will be 13.396%, and
so on.
18. Financing With a Portfolio.
a. Does borrowing a portfolio of currencies offer any possible advantages over the borrowing of
a single foreign currency?
ANSWER: If a firm borrows a single foreign currency, it is especially vulnerable to that
currency’s exchange rate. The firm can lower its vulnerability to any single currency by borrowing
a portfolio.
b. If a firm borrows a portfolio of currencies, what characteristics of the currencies will affect the
potential variability of the portfolio’s effective financing rate? What characteristics would be
desirable from a borrowing firm’s perspective?
ANSWER: Currencies which are volatile and highly correlated with each other could cause the
effective financing rate of the portfolio to be very volatile over time. Ideally, the currencies
comprising the portfolio would have a low degree of volatility or negative correlations. This
would reduce the exchange rate risk of the portfolio.
19. Financing With a Portfolio. Raleigh Corp. needs to borrow funds for one year to finance an
expenditure in the United States. The following interest rates are available:
U.S.
Canada
Japan
Borrowing Rate
10%
6%
5%
The percentage change in the spot rates of the Canadian dollar and Japanese yen over the next year
are as follows:
Canadian Dollar
Percentage Change
in Spot Rate
Probability
10%
5%
90%
2%
Japanese Yen
Percentage Change
Probability
in Spot Rate
20%
6%
80%
1%
If Raleigh Corporation borrows a portfolio, 50 percent of funds from Canadian dollars and 50
percent of funds from yen, determine the probability distribution of the effective financing rate of
the portfolio. What is the probability that Raleigh will incur a higher effective financing rate from
borrowing this portfolio than from borrowing U.S. dollars?
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347
ANSWER:
Currency
Canadian dollar
Canadian dollar
Japanese yen
Japanese yen
Possible Joint
Effective
Financing Rate
JY
C$
11.3%
11.3%
11.3
6.05
8.12
11.3
8.12
6.05
Interest
Rate
6%
6%
5%
5%
Possible
% Change
5%
2%
6%
1%
Effective
Financing
Rate Based on
that Change
11.3%
8.12%
11.3%
6.05%
Joint
Probability
(10%)(20%) = 2%
(10%)(80%) = 8%
(90%)(20%) = 18%
(90%)(80%) = 72%
Probability
10%
90%
20%
80%
Effective Financing
Rate of Portfolio
.5(11.3%) + .5(11.3%) = 11.3%
.5(11.3%) + .5(6.05%) = 8.675%
.5(8.12%) + .5(11.3%) = 9.71%
.5(8.12%) + .5(6.05%) = 7.085%
There is a 2 percent chance that Raleigh will incur a higher effective financing rate from
borrowing the portfolio.
Solution to Continuing Case Problem: Blades, Inc.
1. What is the amount, in baht, that Blades needs to borrow to cover the payments due to the Thai
suppliers? What is the amount, in yen, that Blades needs to borrow to cover the payments due to
the Thai suppliers?
ANSWER: Since Blades will purchase materials necessary to manufacture 120,000 pairs of
“Speedos,” and since the cost per pair will approximately be 3,500 Thai baht, it will need to obtain
a loan for the equivalent of 120,000 × 3,500 = 420,000,000 Thai baht.
If Blades borrows in yen, the yen would be converted to Thai baht in order to pay the Thai
supplier. Thus, Blades will have to obtain a loan for THB420,000,000/THB0.347826 =
¥1,207,500,302.
2. Given that Blades will use the receipts from the receivables in Thailand to repay the loan and that
Blades plans to remit all baht-denominated cash flows back to the U.S. parent whether it borrows
in baht or yen, does the future value of the yen with respect to the baht affect the cost of the loan if
Blades borrows in yen?
ANSWER: Given that all baht-denominated cash flows generated by Blades’ Thai subsidiary are
remitted back to the U.S., Blades cost of the yen loan will be affected by the future value of the
yen with respect to the baht. Blades will first borrow yen, convert the yen to baht to pay the
suppliers, and then convert baht to yen in six months to repay the yen loan. If the yen appreciates
relative to the baht over the life of the loan, Blades’ effective financing rate of borrowing in yen
will increase.
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International Financial Management
3. Using a spreadsheet, compute the expected amount (in U.S. dollars) that will be remitted back to
the U.S. in six months if Blades finances its working capital requirements by borrowing baht
versus borrowing yen. Based on your analysis, should Blades obtain a yen- or baht-denominated
loan?
ANSWER: (See spreadsheet attached.) If Blades borrows in Thai baht, the expected amount
remitted back to the U.S. in six months is $3,501,653. If Blades borrow in Japanese yen, the
expected amount remitted back to the U.S. in six months is $3,627,438. Thus, it appears that
Blades should obtain a yen-denominated loan.
Computation of Expected Change in Value of Thai Baht (Relative
to the Dollar)
(1)
(2)
Possible Rate of Change in the
Thai Baht Over the Life of the Loan
–3%
–2%
–1%
0%
1%
Probability of
Occurrence
30%
30%
20%
15%
5%
(3) = (1) × (2)
Product
–0.90%
–0.60%
–0.20%
0.00%
0.05%
–1.65% = Expected Change
Computation of Expected Change in Value of Japanese Yen
(Relative to the Baht)
(1)
Possible Rate of Change in the
Japanese Yen Over the Life of the Loan
2%
1%
0%
–1%
–2%
(2)
Probability of
Occurrence
30%
30%
20%
15%
5%
(3) = (1) × (2)
Product
0.60%
0.30%
0.00%
–0.15%
–0.10%
0.65% = Expected Change
(1) Blades Borrows in Thai Baht
Computation of Expected Baht-Dollar Exchange Rate in Six Months
Current Spot Rate of Baht
Expected Percentage Change in Baht
Expected Value of Baht in Six Months ($0.023 × [1 – 1.65%])
$0.0230
–1.65%
$0.0226205
Computation of Baht to Be Remitted to the U.S. Parent:
Baht Receivables (120,000 pairs × 5,000 baht per pair)
Baht Loan Repayment (420,000,000 × 1.06)
Baht to Be Remitted to the U.S. (600,000,000 – 445,200,000)
Expected Dollar Amount Remitted in Six Months (154,800,000
× $0.0226205)
$3,501,653
THB 600,000,000
THB 445,200,000
THB 154,800,000
Chapter 20: Short-Term Financing
349
(2) Blades Borrows in Japanese Yen
Computation of Expected Yen-Baht Exchange Rate in Six Months
Current Spot Rate of Yen
Expected Percentage Change in Yen
Expected Value of Yen in Six Months (THB0.347826 × [1 +
0.65%])
Computation of Baht to Be Remitted to the U.S. Parent:
Baht Receivables (120,000 pairs × 5,000 baht per pair)
Yen Needed to Repay Loan (1,207,500,302 yen × 1.04)
Baht Needed to Repay Loan (1,255,800,314 yen ×
THB0.350087)
Baht to Be Remitted to the U.S. (600,000,000 – 439,639,365)
Expected Dollar Amount Remitted in Six Months (160,360,635
× $0.0226205)
THB 0.347826
0.65%
THB 0.350087
THB 600,000,000
1,255,800,314
THB 439,639,365
THB 160,360,635
$3,627,438
Solution to Supplemental Case: Flyer Company
a. The optimal portfolio is dependent on your degree of risk aversion. By converting the information
in the table above into 4 bar charts (showing the probability distribution), one above another, you
can review the risk-return tradeoff.
By using a spreadsheet format, the percentage changes in exchange rates can be easily computed.
Using these percentage changes along with the interest rates, the effective financing rate can be
computed for each currency under each scenario. The effective financing rates are provided below
for each scenario, along with the expected value of the effective financing rate (using the
probabilities assigned to each scenario):
Currency
Australian dollar
British pound
Canadian dollar
Japanese yen
Mexican peso
New Zealand dollar
Singapore dollar
South African rand
U.S. dollar
Venezuelan bolivar
Strong $
Scenario
–0.56%
4.56
9.71
–1.00
–8.18
–5.48
–4.60
2.19
9.00
2.20
Somewhat
Stable $
Scenario
14.51%
14.48
9.71
11.60
13.47
5.22
1.76
5.59
9.00
10.60
Weak $
Scenario
28.07%
21.10
17.45
29.60
18.06
12.35
10.24
15.81
9.00
20.40
Expected Value
of Effective
Financing Rate
14.05%
13.49
12.03
13.22
8.35
4.14
2.40
7.64
9.00
11.02
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International Financial Management
Type of Portfolio
Risk neutral
Balanced
Conservative
Ultra-conservative
A$
0
0
0
0
Percentage of Funds Borrowed from:
BP
C$
JY
MXP NZ$
0
0
0
0
0
0
0
0
25
25
0
0
0
10
10
0
0
0
0
0
S$
100
25
10
0
SAR
0
25
10
0
US$
0
0
60
100
VB
0
0
0
0
Each portfolio’s effective financing rates are determined as a sum of weighted effective financing rates
under each scenario.
Portfolio
Risk neutral
Balanced
Conservative
Ultra-conservative
Portfolio’s Effective
Financing Rate Based on a:
Strong $
Stable $
Weak $
Scenario
Scenario
Scenario
–4.60%
1.76%
10.24%
–4.02
6.51
14.11
3.79
8.00
11.04
9.00
9.00
9.00
Expected Value
of Effective
Financing Rate
2.40%
5.63
7.65
9.00
The decision of which portfolio to use would be based on your degree of risk aversion. By converting
the table above into four bar charts, (showing the profitability distribution), one above another, you
can review the tradeoff between lower financing costs and risk.
Small Business Dilemma
Short-Term Financing by the Sports Exports Company
1. Should Jim borrow dollars or pounds to finance his joint venture business? Why?
ANSWER: Jim should borrow pounds. Although the British interest rate is slightly higher, Jim
could offset part of his firm’s exposure by borrowing British pounds. Jim can use some of his
future receivables in pounds to repay the British loan, thereby reducing the amount of pounds that
have to be converted into dollars.
2. Jim could also borrow euros at an interest rate that is lower than the U.S. or British rate. The
values of the euro and pound tend to move in the same direction against the dollar but not always
by the same degree. Would borrowing euros to support the British joint venture result in more
exposure to exchange rate risk than borrowing pounds? Would it result in more exposure to
exchange rate risk than borrowing dollars?
ANSWER: Borrowing euros would result in more exchange rate risk than borrowing pounds,
because the euros would have to be converted into pounds to support the British venture, but
payment on the loan would be in euros. If the euro appreciated against the pound over time, it
would take more pounds to pay off the loan.
Chapter 20: Short-Term Financing
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Borrowing euros would be less risky (when using the funds to finance the British venture) than
borrowing dollars, because the movements in the euro and the pound are highly correlated. If the
pounds’ value declined against the dollar, so would the euro (in most cases), so that the amount of
pounds needed to pay this loan would be less than the amount needed to pay a loan denominated
in dollars.