Page 139 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes The point is that, without some kind of hedge against the uncertainties of future cash flows, the
firm incurs costs that could be avoided by the use of a hedging strategy. Of course, there is a
trade-off between the cost of the hedge and the expected costs that it avoids. It would not be cost-
effective to hedge against all possible future costs if their probability of occurrence was very
small. Because of this trade-off, it is necessary to understand the relative costs and other
characteristics of the various methods commonly used to hedge the uncertainty of the firm’s
cash flows. Some of the possible hedging methods and their costs are discussed below:

Holding a Stock of Extra Cash

We refer here to a stock of cash kept by the firm beyond that needed for transactions. Cash is the
most flexible but the most costly hedge available to the firm. It is the most flexible in that it can
hedge a shortage in any circumstances, at any time, with no transaction costs. If the firm holds a
stock of extra the temporary investment. Interest rate futures and options can also be used to
hedge interest rate risks that do not arise as the result of uncertainties in the firm’s cash flow, but
instead occur solely because of changing interest rates between the time of the forecast and the
planned investment of financing.
Basics of Interest Rate Futures Contracts

The discussion of futures can be obscured by the jargon of the futures market. Leaving the reader
is bewildered and uninformed. If a few basic principles are kept in mind, much of this confusion
can be avoided. First, we must always remember that the proper name for any future is a futures
contract, with the emphasis on contract. A futures contract is just a contract between one party
and another for the future delivery of a commodity. In this contract, the price and delivery date
are specified. By specifying the price, both the buyer and seller are hedged against price
fluctuations between the date on which the contract is sold and the delivery date. Futures
contracts are commonly made on numerous types of goods.
And, since the futures contract specifies delivery at a fixed price but the market price of the
commodity fluctuates with supply and demand, the value of the futures contract will fluctuate
with the market price of the commodity. If the price of the commodity rises, so will the value of
the futures contract specifying the purchase of the commodity at a lower price. However, one
major difference between run-of-the-mill legal contracts for future delivery of goods and the
future contracts discussed here is that these future contracts are traded on exchanges. This enables
the parties to satisfy the contract and to realise gains or lasses before the maturity of the contract
by selling the contract to a third party.
In these exchanges, the clearing house (which manages the exchange) guarantees the performance
of both parties to the contract and offsets opposing transactions. An example of this offset
procedure is useful. Suppose that a firm purchases a contract for the future delivery of a
commodity. Later, it decides to take its gain or loss on this contract. It may do so by selling a
contract for the delivery of the same commodity on the same delivery date at the same price. In
the language of the futures market, the firm is both long in the contract (because it contracted to
take delivery of the commodity) and short in the contract (because it contracted to deliver the
commodity). In futures markets, the clearinghouse will net out these offsetting transactions, and
the firms need not be involved thereafter.
When firm decides to take its gain or loss on a futures contract a large transfer of cash between
the firm and its futures broker is not required. Most futures contracts are purchased on the
margin; the firm givens the futures broker a relatively small deposit toward the total price of
the contract. In the futures market, the amount of the deposit (the margin) is adjusted every day,
and the firm gains or loses the difference in value. If the value of its contract goes up, the margin
account with the futures broker is credited; if it goes down. The margin account is reduced.

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