Page 143 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes very useful for the firm to be able to find a ready buyer or seller without the action of buying or
selling affecting the market price of the contract. In this market, there are so few contracts traded
that this may not be possible, the very act of closing out the position may reduce the firm’s
returns via the act’s effect on the market price of the contracts. If the basis changes, or if the firm
is not able to exactly match the principal value of the instrument with the principal value of the
hedge (as in this case), the changes in the value of the instrument will not be exactly offset with
changes in the value of the future or option.
While basis risk is a significant consideration in using futures and options to hedge risk, its
importance should not be overemphasised. When the firm uses these hedges, the prime variable
it is attempting to hedge is the overall level of interest rates. Compared to changes in these
general levels, changes in the basis are often rather small. Despite problems of thin markets and
basis risk, the use of futures, and options on these futures, provides results that are significantly
safer than unhedged strategies.

Self Assessment

Fill in the blanks:

16. Options are instruments whereby the right is given by the option seller to the option
buyer to buy or sell a specific ............................ at a specific ............................ on or before a
specific date.
17. Future contracts are ............................ contracts, which are traded on the exchanges.
18. The ............................ is eventually applied to the purchase pries should the buyer take
delivery.
19. The ............................ of futures contract in anticipation of borrowing locks in the rate of
borrowing.
20. Options are of two types – ............................ and ............................ .
21. A cash budget allows a firm to evaluate and plan for its ............................
22. A very common mistake regarding futures contracts is to think of the ....................... as an
out-of-pocket transaction cost.

8.6 Summary

 Cash forecasting is extremely important to most firms.
 It enables them to anticipate periods of surplus cash and periods where financing will be
necessary.
 This anticipation is the reason that cash forecasts are generated.
 Daily cash forecasts attempt to project cash inflows and outflows on a daily basis one or
more days into the future.
 This is perhaps the most difficult forecasting to perform accurately.
 Even though a firm may know precisely its revenues for the month, it may have difficulty
determining specific cash inflows for given days of the month.
 Collection rate uncertainty is the uncertainty regarding the firm’s actual future collection
patterns of receivables.

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