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Relationship between the market deviation from the interest rate parity and the net working capital decision of the U.S. multinational corporations.

INTRODUCTION

Short-term borrowing and investing decisions that involve securities trading in the money markets are an important practical part of international financial management. Short-term borrowing and investing can be used for management of foreign exchange risk associated with cash inflow and outflow in foreign currencies. Interest Rate Parity (IRP) shows a theoretical relationship existing between the short-term interest rates of two countries and foreign exchange rates, and it is an arbitrage condition that must hold when international financial markets are in equilibrium (Eun & Resnick, 2007). According to the theory, the currency with higher (lower) short-term interest rate will exhibit a discount (premium) in its forward exchange rate. In short, the theory states that certain economic forces work toward equalizing investment yields and borrowing costs in different currencies of different countries.

Multinational corporations that have short-term accounts receivable/payable denominated in foreign currencies are exposed to foreign exchange risk (transaction exposure). The most popular technique of hedging transaction exposure is forward hedge that involves the use of a forward contract to buy or sell an amount of foreign currency at a contractual forward rate. According to a survey by Jesswein, Kwok, and Folks (1995), 93 percent of the sample Fortune 500 firms used forward hedge. A money market hedge, that is not as extensively as the forward hedge, is an alternative technique for managing the foreign exchange risk of the short-term cash flow position of a firm, and it involves borrowing and investing in domestic and foreign short-term money markets based on thorough analysis of foreign exchange markets and domestic and foreign money markets.

According to Interest Rate Parity (IRP), for the international financial markets to be in equilibrium, the result of forward hedge of receivables or payables in foreign currency must be identical to that of the money market hedge.

In this study, the author has examined the deviations of international financial markets from the prediction of the Interest Rate Parity (IRP) relationship before and after the onset of the euro zone debt crisis for two major foreign currencies: the euro ([euro]) and the British pound ([pounds sterling]). Then the author further examined how net working capital of the U.S. multinational corporations has been affected by the implementation of money market hedge.

LITERATURE REVIEW

Interest Rate Parity

Eun and Resnick (2007) explains the theory as follows: Given short-term (say 1 year) interest rates in domestic (say U.S.) and foreign money markets [i.sub.h] and [i.sub.f], and spot exchange and forward exchange rates S and F, there are two alternative ways of investing (or borrowing) short-term funds: (1) investing (or borrowing) S units of domestic currency (that is equivalent to one unit of foreign currency) in domestic money markets at [i.sub.h] to receive (or repay) $S x (1 + [i.sub.h]) in one year, or (2) attempting covered interest arbitrage that involves investing (or borrowing) one unit of foreign currency in the foreign money market at if after exchanging the funds for the foreign currency at the spot exchange rate S, and selling (or buying) the investment value (or repayment value) forward at F to receive (or to repay) $F x (1 + [i.sub.f]). According to Copeland and Weston (1988), the interest parity theorem holds that the ratio of the forward and spot exchange rates will equal the ratio of foreign and domestic interest rates, thus the investment values (or repayment values) of the two alternatives should be the same for the short-term international financial markets to be in equilibrium such that:

$S(1 + [i.sub.h]) = $F x (1 + [i.sub.f])

In short, the above IRP equation says that the short term investment (or borrowing) in the domestic money market must be equal to the short term investment (or borrowing) in the foreign money market, then sold (or bought) forward for the home currency at forward exchange rate F to lock in the investment (or repayment) values. The above IRP equation can be rearranged:

([i.sub.h] - [i.sub.f])/(1 + [i.sub.f]) = (F - S)/S

The above IRP equations clearly show the linkage between two countries' money markets and foreign exchange markets (Eiteman, Stonehill, & Moffett, 1988) such that: As long as interest rates are the same between home and foreign money markets, the forward rate will be the same as the spot rate. However, if there exists a difference in interest rates between domestic and foreign money markets, the difference is reflected in the foreign exchange markets as a forward premium (i.e., F > S) or a forward discount (i.e., F < S). When the home currency exhibits a forward discount (i.e., the foreign currency exhibits a forward premium against the home currency), the home interest rate is higher than the foreign interest rate to compensate for the expected depreciation of the home currency as implied by the forward discount. When it is, however, at a forward premium, the domestic interest rate is lower than the foreign interest rate (Madura, 2008).

Market Deviation

The relationship between interest rates and exchange rates in international financial markets as described by Interest Rate Parity may not hold precisely all the time due to extraneous factors such as government intervention and transaction costs. Following the measure of Otani and Tiwari (1981), the author defines the market deviation from IRP as:

DEV = [S(1 + [i.sub.h])/ F(1 + [i.sub.f])] - 1

If the short-term international financial markets are in equilibrium as described by IRP, there is zero deviation, i.e., DEV = 0. In other words, when IRP holds, an investment (or borrowing) of S units of the home currency in the short-term domestic money market should be equal to one unit of foreign currency that is invested (or borrowed) in foreign money market and hedged by selling (or buying) forward (i.e. S(1 + [i.sub.h]) = F(1 + [i.sub.f]). Substantial non-zero deviation indicates that IRP does not hold. Firm's choice of hedging technique depends upon whether it has receivables (i.e. cash inflow) or payables (i.e. cash outflow) denominated in foreign currency. Under market condition such that the deviation is positive (i.e. S(1 + [i.sub.h]) > F(1 + [i.sub.f])), the short term investment in domestic money markets is better than the alternative foreign investment, and short term borrowing in foreign money markets is better than domestic borrowing. If it is negative, however, (i.e. S(1 + [i.sub.h]) < F(1 + [i.sub.f])), the foreign investment (commonly called covered interest arbitrage) is better because it results in a larger investment value at the end of the investment horizon, and borrowing in domestic markets is better than borrowing in the foreign money markets (Levi, 2009).

Forward Hedge vs. Money Market Hedge

Eun and Resnick (2007) define transaction exposure as the sensitivity of realized domestic currency value of the firm's contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. A firm's expected short-term cash inflow and cash outflow (for its accounts receivable and accounts payable) is contractually fixed but is subject to foreign exchange risk due to randomly changing foreign currency value. In an effort to reduce this foreign exchange risk involving its cash flow positions at the time of contract settlement, it can consider using different financial hedging techniques. With a forward hedge, a firm can effectively eliminate foreign exchange risk by locking in the price of foreign currency (i.e., the forward exchange rate) at which the contractual amount is to be sold or bought. A money market hedge involves short-term borrowing or lending in both the domestic money market and the foreign money market (Shapiro, 2009).

The Case of Accounts Receivable

1. The forward hedge attempts to reduce foreign exchange risk by selling the amount of foreign currency in the contract of accounts receivable (say 1 [pounds sterling]) at a fixed price (i.e. forward exchange rate). At the time of settlement, the firm will receive a locked-in certain amount (i.e. $F) in home currency that is free of foreign exchange risk.

2. A money market hedge can be implemented in three steps:

a) From a foreign bank, borrow [pounds sterling](1/(1 + [i.sub.[pounds sterling]]), the maximum amount that can be borrowed using the receivables as collateral. The maximum borrowable amount is equal to the present value of the contractual amount.

b) Exchange [pounds sterling](1/(1 + [i.sub.[pounds sterling]]) at the spot rate, S, for $S/(1 + [i.sub.[pounds sterling]]) in the spot foreign exchange market.

c) Invest the amount in a U.S. bank at [i.sub.$] to receive $S(1 + [i.sub.$])/(1 + [i.sub.[pounds sterling]]) that is also free of foreign exchange risk. Uncertain cash inflow of short-term assets (i.e. accounts receivable) denominated in a foreign currency is effectively converted into certain cash inflow in home currency that is free of exchange risk.

The Case of Accounts Payable

1. A forward market hedge attempts to reduce foreign exchange risk by buying the amount of foreign currency in the contract of accounts payable (say 1 [pounds sterling]) at a fixed price (i.e. forward exchange rate). At the time of settlement, the firm will pay a locked-in certain amount (i.e. $F) in home currency that is free of foreign exchange risk.

2. A money market hedge can be implemented in three steps:

a) From a domestic bank, borrow at the interest rate [i.sub.$] an amount equal to $S/(1 + [i.sub.[pounds sterling]]).

b) Exchange the borrowed amount $S/(1 + [i.sub.[pounds sterling]]) for [pounds sterling](1/(1 + [i.sub.[pounds sterling]]) at S in the spot foreign exchange market.

c) Invest the amount in a foreign bank at [i.sub.[pounds sterling]] to make 1 [pounds sterling] that will be used to settle the payable at the end of the term. Simultaneously, pay back with interest to the domestic bank an amount $S(1 + [i.sub.$])/(1 + [i.sub.[pounds sterling]]). An uncertain cash outflow of short-term liabilities (i.e. accounts payable) denominated in foreign currency is effectively converted into certain cash outflow in home currency that is free of foreign exchange risk.

In summary, a forward hedge would result in $F, whereas a money market hedge would result in $S(1 + [i.sub.[pounds sterling]]) for both receivables and payables. Both hedging techniques convert a foreign currency-denominated cash inflow of receivable or cash outflow of payable into home currency-denominated cash flows, thus eliminating foreign exchange risk. For the international financial markets to be in equilibrium without arbitrage opportunities, the two results must be equal to each other: $F = $S(1 + [i.sub.$])/([i.sub.[pounds sterling]]), which is nothing but the IRP equation. In other words, if IRP holds, the end results of the forward hedge and the money market hedge are the same.

EMPIRICAL MODEL FOR NET WORKING CAPITAL DECISION UNDER TWO DIFFERENT MARKET CONDITIONS

Net working capital (i.e. accounts receivables minus accounts payables) depends upon a firm's choice of hedging technique between forward hedge and money market hedge under two different market conditions (i.e. DEV > 0 or DEV < 0). The relationship between multinational firm's net working capital position and international financial market conditions can be postulated as follows:

1. If DEV > 0 (i.e. $S(1 + [i.sub.h]) > $F x (1 + [i.sub.f]));

For cash inflow of accounts receivable, the money market hedge should be chosen because the domestic investment of the borrowed amount in the foreign money market will result in a larger amount in home currency than selling the receivable forward. Thus, foreign accounts receivables are replaced by domestic accounts receivable with a net increase in current asset by the amount equal to: $S(1 + [i.sub.h]) minus $F x (1 + [i.sub.f])).

For cash outflow of accounts payable, the forward hedge should be chosen because it entails a smaller amount in home currency than borrowing in the domestic money market and investing in the foreign money market. Thus, foreign currency denominated accounts payable remain and domestic accounts payables are not created.

Overall, a firm's current assets increase whereas current liabilities remain the same, thus resulting in an increase in net working capital.

2. If DEV < 0 (i.e. $S(1 + [i.sub.h]) < $F x (1 + [i.sub.f]));

For cash inflow of accounts receivables, the forward hedge should be chosen because it results in larger cash inflow in home currency than money market hedge does. Thus, foreign currency-denominated receivables remain, and there would be no domestic accounts receivables created.

For cash outflow of accounts payable, the money market hedge will be chosen because domestic borrowing to take care of foreign currency-denominated accounts payable is less costly than forward hedge. Thus, foreign accounts payable are replaced by domestic accounts payable with a net decrease in current liability by the amount equal to: $F x (1 + [i.sub.f])) minus $S(1 + [i.sub.h]).

Overall, a firm's current liabilities decrease whereas current assets remain the same, thus resulting in an increase in net working capital as well.

In a nutshell, depending upon international financial market conditions that result in DEV either positive or negative, conversion of current assets and current liabilities occurs as multinational corporations implement short-term financial hedging: (i) when DEV>0, current assets increases as foreign currency-denominated receivables are converted into domestic receivables that result in a larger locked-in cash inflow; (ii) when DEV<0, current liabilities decrease as foreign currency denominated payables are converted into domestic payables that result in a smaller locked-in cash outflow. Under both circumstances, net working capital should increase.

Specifically, this paper tests empirically the significance of the relationship between multinational firm's net working capital position and international financial market conditions based on market data and firm-specific data. Dependent variable, net working capital (NWC), is regressed on independent variable DEV for euro and pound, respectively under two market conditions DEV>0 and DEV<0 in an empirical simple regression model:

[NWC.sub.i] = [alpha] + [beta] x [DEV.sub.i] + [[epsilon].sub.i]

METHODOLOGY

Sample and Data Collection

Foreign exchange rates and money market interest rates for this study were collected manually from the Financial Times markets data available at http://www.ft.com/home/us. Spot and one year forward exchange rates for the euro ([euro]) and the British pound ([pounds sterling]) are collected for 197 weeks during which the euro zone debt crisis occurred. From the same website, 1-year LIBOR interest rates for the US, the EU, and the United Kingdom were gathered. The exchange rates and interest rates were used to compute the market deviation from the Interest Rate Parity for statistical tests. The conjecture is that the market deviation during this period is high because of negative impact of the euro debt crisis on the euro's currency value. Also, the increase in the short-term interest rates of EU member countries reflect increases in risk premiums due to excessive government debt levels, trade imbalances, diminishing market confidence in the fundamentals of economy and doubts about government ability or resolution to contain the crisis.

Firm-specific data were collected manually from the Security and Exchange Commission's EDGAR database which lists financial reports of firms. Quarterly 10-Q reports of the Dow Jones thirty blue chip industrial firms were examined for short-term assets and liabilities under Derivatives from the third quarter of 2007 to the third quarter of 2011. 17 firms appeared to have short-term assets and liabilities under Derivatives in their 10-Q reports. Khoury, Sarkis, and Chan (1988) show distinction of contractual cash flows from noncontractual cash flows lend itself to the analysis of the effect of deviation on the management of transaction exposure that results in the change in net working capital.

This study is based on contractual cash flow data from the "Derivatives" section of 10-Q. For each firm, net short-term asset (i.e. the difference between current assets and current liabilities) is calculated. It is found that the 17 sample firms on average have larger current assets than current liabilities throughout the time except for the third quarter of 2007.

Data Analysis

Throughout the entire study period, the two foreign currencies exhibit deviations from the IRP equilibrium condition. Except for a period between mid-2009 and early 2010, the euro and the pound exhibit consistently negative deviations. Negative deviations (i.e., S(1 + [i.sub.h]) < F(1 + [i.sub.f])) of the euro and the pound indicate that: short-term investment values in the euro zone and the UK money markets is larger than investment values in the US money markets, but short term borrowing is more costly than in the US money markets. Despite higher interest rates in their money markets than in the US, the euro and the pound were over-valued in forward markets, thus providing opportunities for short-term gains by selling euro- or pound-denominated receivables forward. Thus, foreign currency-denominated receivables remain, and there would be no domestic accounts receivables created with no change in net working capital by forward hedge.

However, for payables, since forward hedge is more costly than domestic short term borrowing and investing the proceeds in euro and British money markets, this money market hedge would create domestic payables with a less locked-in cash outflow than that of forward hedge, thus resulting in an increase in net working capital. This finding of negative deviations is consistent with reports of stable or even higher-priced euro than before (Reuters, 2011). Negative deviations of the pound are very similar to euro's, which indicates a high correlation between the euro and the pound.

T-TEST FOR COMPARISON OF DEVIATIONS BETWEEN CURRENCIES

Statistical significance of the deviations from the prediction of IRP is tested. The null hypothesis is that the average size of deviation should be zero. As reported in Table 1, the euro and the pound appear to have statistically significant negative deviations throughout time, before and after the onset of the crisis. Overall, the international financial markets represented by the two currencies are off the equilibrium predicted by the IRP.

RESULTS OF THIS STUDY

Out of the entire 197 weeks (from 10-1-2007 until 9-12-2011) covered in this study, except for a period between mid-2009 and early 2010, the euro and the pound exhibit consistently negative deviations (162 week out of 197 weeks) indicating that short-term investment values in the euro zone and the UK money markets is larger than investment values in the US money markets, but short term borrowing is more costly than in the US money markets.

As shown in Table 2, when market conditions is such that DEV < 0, the dependent variable NWC is negatively related to the independent variable DEV[euro]. The relationship is statistically significant with its p-value close to zero, supporting the hypothesis of increasing net working capital with negative deviation of the currency from the IRP.

Under the market condition of positive deviations, as shown in Table 3, the relationship between NWC and [DEV.sub.[euro]] is consistent with the hypothesized positive relationship (i.e. increasing net working capital with positive DEV), it is statistically significant at [alpha] = 10% with p-value of 0.0781.

Table 4 and Table 5 show the results of the same regression analysis done for British pound for the same period. Out of 197 quarters included in this study, pound exhibited negative deviation (i.e. decreasing net working capital) during 170 weeks, and it has positive deviations (i.e. increasing net working capital) only for 27 weeks.

Table 4 shows a statistically significant negative relationship between net working capital and the deviation of pound with p-value close to zero. This relationship is consistent with the hypothesis of increasing net working capital under the market condition of negative deviation of the pound from the IRP.

Under the market condition of positive deviations, as shown in Table 5, the positive relationship between NWC and [DEV.sub.[euro]] is statistically significant with its p-value close to zero, and this result is in support of the hypothesized positive relationship (i.e. increasing net working capital with positive DEV).

Overall, statistical tests confirm the postulated relationship between the market deviation and the U.S. multinational firm's net working capital: (i) when DEV>0, current assets increases as foreign currency-denominated receivables are converted into domestic receivables that result in a larger locked-in cash inflow through money market hedge than in forward hedge; (ii) when DEV<0, current liabilities decrease as foreign currency denominated payables are converted into domestic payables that result in a smaller locked-in cash outflow through money market hedge than in forward hedge, thus net working capital should increases under both circumstances.

CONCLUSION

In this paper, the IRP is revisited to explore the implications of the market deviations from Interest Rate Parity for a firm's transaction exposure management. The study formulated the choice of hedging method between forward hedge and money market hedge depending upon market deviations, measuring market deviations from the IRP for the euro and the pound for 197 weeks from 10-1-2007 until 9-12-2011.

It is found that: (1) international financial markets are off the equilibrium predicted by the IRP throughout the entire time period for the two currencies. (2) for the most part of the study period, the euro and the pound exhibit negative market deviations from the IRP indicating that the investment yield (and short-term borrowing cost) in the euro zone and the UK money market is higher than in the US money market throughout the period. (3) US multinational firms implement money market hedge (mainly for payables denominated in euro and pound) that results in an increase in net working capital.

RECOMMENDATION FOR FUTURE RESEARCH

Although statistical tests of this study strongly support the hypothesized relationship between the financial market conditions and the firm's short term net working capital, it covers only two foreign currencies (i.e. euro and pound) for a limited time period of four years from the third quarter of 2007 to the third quarter of 2011. Future researches that include most of key foreign currencies in global financial markets such as Japanese yen, Swiss franc, and Canadian dollar over a longer time period are needed.

REFERENCES

Copeland, T, & Weston, J. F. (1988). Financial Theory and Corporate Policy, Addison Wesley, Third Edition.

Eiteman D. K., Stonehill, A. I., & Moffett, M. H. (2012), Multinational Business Finance, Pearson Education, Limited, Thirteenth Edition.

Eun, C.S., & Resnick, B.G. (2007). International Financial Management, McGraw-Hill Erwin, Fourth Edition.

Jasswein, K., Chuck C., Kwok, Y., & Folks, W. Jr. (1985, Fall). Corporate Use of Innovative Foreign Exchange Risk Management Products. Columbia Journal of World Business, 70-82.

Khoury, Sarkis J., & Chan, K.H. (1988, Winter). Hedging Foreign Exchange Risk: Selecting the Optimal Tool. Midland Corporate Finance Journal, 40-52.

Levi, M. (2009). International Finance. McGraw Hill, Fifth Edition.

Madura, J. (2008). International Financial Management, South-Western, Eleventh Edition

Otani, I., & Tiwari, S. (1981). Capital Controls and Interest Rate Parity: The Japanese Experience, 1978-81. International Monetary Fund Staff Papers 28, 793-815.

Shapiro, A. (2009). Multinational Financial Management. Prentice Hall, Ninth Edition.

Dolan, M. (2011, November 15). Analysis: Puzzle over euro's "mysterious" stability. Reuters.

Minje Jung

University of Central Oklahoma

Minje Jung is a professor of finance at the University of Central Oklahoma. This is one of a series of research papers on the Interest Rate Parity and hedging in foreign currency markets.

Table 1
T-tests for Deviations

                Euro          Pound

Mean        -0.002390623   -0.002575492
Std. Dev.   0.003383524    0.003196949
n               197            197
t-test         -9.917        -11.307

Table 2
Regression of NWC on DEV for Euro (where [DEV.sub.[euro]] < 0)

Regression Statistics

Multiple R     0.244647
R2             0.059852
Adj R2         0.053976
S.E.           11822.38
Observations   162

ANOVA

                        df           SS         MS         F

Regression              1         1.42E+09   1.42E+09   10.18598
Residual               160        2.24E+10    1.4E+08
Total                  161        2.38E+10

                   Coefficients   Standard    t Stat    P-value
                                   Error

Intercept            20799.97     1311.019    15.8655   1.16E-34
[DEV.sub.[euro]]     -928530      290933.8   -3.19155   0.001704

Table 3
Regression of NWC on DEV for Euro (where [DEV.sub.[euro]] > 0)

Regression Statistics

Multiple R      0.301774
[R.sup.2]       0.091068
Adj [R.sup.2]   0.063524
S.E.            10442.45
Observations    35

ANOVA
             df      SS         MS         F       Significance F

Regression   1    3.61E+08   3.61E+08   3.306337       0.0781
Residual     33    3.6E+09   1.09E+08
Total        34   3.96E+09

Table 4
Regression of NWC on DEV for Pound (where
[DEV.sub.[pounds sterling]] < 0)

Regression Statistics

Multiple R      0.357089
[R.sup.2]       0.127512
Adj [R.sup.2]   0.122319
S.E.            12277.4
Observations    170

ANOVA

                  df           SS         MS         F

Regression        1          3.7E+09    3.7E+09    24.55284

Residual         168        2.53E+10   1.51E+08

Total            169         2.9E+10

             Coefficients   Standard    t Stat    P-value
                             Error

Intercept      19777.12     1398.473   14.14194   2.06E-30

[DEV.sub.      -1589036     320688.1   -4.95508   1.75E-06
[pounds
sterling]]

Table 5
Regression of NWC on DEV for Pound (where [DEV.sub.[pounds sterling]]
> 0)

Regression Statistics

Multiple R      0.568095
[R.sup.2]       0.322732
Adj [R.sup.2]   0.295641
S.E.            7253.255
Observations    27

ANOVA
                        df           SS         MS         F

Regression              1         6.27E+08   6.27E+08    11.913
Residual                25        1.32E+09   52609707
Total                   26        1.94E+09

                   Coefficients   Standard    t Stat    P-value
                                   Error

Intercept            43116.48     3102.732   13.89629   2.91E-13
[DEV.sub.[pounds      6339259      1836656    3.45152   0.001993
  sterling]]
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Author:Jung, Minje
Publication:International Journal of Business, Accounting and Finance (IJBAF)
Geographic Code:1USA
Date:Sep 22, 2013
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