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Unit 8: Cash Planning
when the firm has invested temporary cash in investments with maturities matching the expected Notes
future times when the cash will be needed (to take advantage of up-sloping yield curve effects),
the firm is subject to interest rate risk should actual cash flows be such that the firm must
liquidate these investments before maturity. Futures contracts themselves will not work in this
situation because the firm does not know whether there will be a shortage which will necessitate
the selling of the investments. The firm needs an instrument it can exercise if the shortage
occurs, and it is forced to sell its investments. One possible strategy is to purchase a put option
on a futures contract for investment securities.
Self Assessment
Fill in the blanks:
11. To hedge the risk of changes in interest yields on investments, the firm may purchase a
............................ in the investment instrument.
12. It would not be cost-effective to hedge against all possible future costs if their probability
of occurrence was very............................
13. An effective cash planning and management system should recognize the ............................
and the..........................of cash.
14. If the exercise price of a put option on a financial future is greater than the current market
price of the future, then the value of the option must be at least the ............................
15. An option is a contract to purchase or sell something at a fixed price which may be
exercised or not at the ............................ discretion.
8.5 Future and Options
Future contracts are organised/standardised contracts, which are traded on the exchanges. These
contracts, being standardised and traded on the exchanges are very liquid in nature. In futures
market, clearing corporation/house provides the settlement guarantee.
Options are instruments whereby the right is given by the option seller to the option buyer to
buy or sell a specific asset at a specific price on or before a specific date.
Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price on or before a given future date.
Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.
Problems in Using Interest Rate Options and Futures for Hedging
There are two factors inhibiting the firm in efforts to construct hedges that completely eliminate
the risk of interest rate fluctuations via futures contracts on options on these futures contracts.
These problems are thin markets and basis risk.
In order to close out any position in futures or options on futures, the firm must either
1. Fulfill the contract by taking delivery of the instrument.
2. Take a position opposite to the original contract by selling a contract (for a long) or
buying a contract (for a short). Take the loss or gain, and have the clearing house offset the
transactions.
The latter strategy is by far the most popular, however, it requires that the firm make at least one
additional transactional in the futures marketplace. In making these market transactions, it is
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