Page 141 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes the option to sell the future, and make a gain of the difference. If the current market price
of the future is more than the exercise price of the put option the only value of the put
option is that, over the remaining period, the market price might fall below the exercise
price, giving the ability to make money. The reverse case between exercise price, market
price, and option value occurs for call option.
Using Future and Options on Future to Liaise the Risk in the Cash Forecast

Interest rate futures contracts, and options on these contracts, can be used in two ways to hedge
risk in cash forecast:
1. They can be used to hedge the interest rate risk on future borrowings and investments, or

2. They can be used to hedge the interest rate risk inherent in investing in longer-term
instruments where an unexpected cash shortage may lead to selling these instruments
before maturity.
Let us first consider the hedging of interest rates on future expected, borrowing and investing.
Futures contracts on risk-free securities or options on these contracts can be used in conjunction
with the cash forecast to lock in future rates on this expected borrowing and investment, and
thus to hedge interest rate risk from the fluctuation in these rates between the time the cash
forecast is generated and the time the borrowing or investing is to be executed.
To hedge the risk of changes in interest yields on investments, the firm may purchase a financial
future in the investment instrument.
Because the use of a futures contract to hedge the interest rate of a future investment precludes
the firm from investing should rates fall, some firms use options on futures contracts (rather
than the futures contracts themselves) to hedge future investments even though there is an
out-of-pocket cost to use the option. If options are used, the exercise of the option is at the
discretion of the firm, and it may purchase securities directly in the market rather than through
the option. In this way, it may benefit from rises in rates, though it is protected from their
decline.
The process of hedging the interest cost on future needed financing is parallel to hedging the
interest yield on future investing. However, with regard to financing, the firm wants to hedge
a rate of borrowing (equivalent to selling debt securities), as opposed to lending (equivalent to
buying debt securities). To hedge future borrowings, the firm may sell a futures contract on an
investment instrument for future delivery (go short in the contract). When the firm must buy the
investments for delivery to fulfill (cover) the short in the futures contract, the price of these
instruments will have fallen, and the firm will make a gain on the futures transaction between
the original selling price of the instrument (in the short sale) and the eventual covering price. If
interest rates decline, the opposite effect occurs; the firm’s borrowings are cheaper, but it takes
a loss on the futures transaction (since it will now cost more to buy the securities to cover the
short sale than the original short sale netted to the firm).
Like the purchase of a futures contract in anticipation of investment, the short sale of futures
contract in anticipation of borrowing locks in the rate of borrowing. Similar to the investment
case, the use of options on futures (rather than futures themselves) enables the firm to profit
from fortuitous interest rate movements, but at the cost of the option To use an option to hedge
future borrowing rates, the firm should purchase a put option on in futures contract.

Now let us consider the second application of these contracts in hedging the risks from the cash
forecast: the risk of funds shortage. We previously discussed how hedges such as keeping a stock
of cash and near-cash assets, investing temporarily surplus cash in near-cash assets rather than
longer maturities, or arranging for excess borrowing capacity can address this risk. Recall that

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