If the eastern branch and the western branch worked together, the eastern branch could loan its $15 million to the western branch
If the eastern branch and the 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 take advantage of interest rate differentials or expected exchange rate effects among currencies. Given the data provided in this example, would you recommend 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.
Here is a tip:
A risk that is caused by a change in the exchange rates is termed as exchange rate risk.
Company K can earn an additional interest of $28,500 when both the branches work independently, but when the eastern branch lent money to the western branch, the interest earned by the eastern branch equaled to the interest paid by the western branch.
However, there are some risks involved in the transactions of future currencies, such as exchange rate risk, as the exchange rate is uncertain. Most companies prefer intra-entity transactions rather than taking the loan and investing in external sources. Intra-entity transactions help a company to avoid the exchange rate risk and one of the major reasons is that Company K does not have an international business that helps the company to offset the loss caused by the change in exchange rates. As a result, the eastern branch will lend excess cash to the western branch.
The excess cash of the eastern branch should be borrowed by the western branch because it saves the interest cost paid to the external source if the western branch borrows funds from an external source.