Lecture 5 Flashcards
(17 cards)
Financial Instruments for Managing Input Material Cost and Foreign Exchange Risks:
forward contract, future contracts, and options contract.
Forward contract. Underlying mechanism:
firm agrees to buy an asset at a fixed price at a specific time in the future. The advantages are that it avoids risk and is customized for the buyer. The disadvantages is that it is costly, and inflexible.
Future contract:
The firm agrees to buy a standardized amount of an asset at a fixed price and price exchange at a standardized delivery time in the future. The advantages is that it is risk avoidant and can be more easily traded and thereby less costly. The disadvantage is that it is inflexible in terms of delivery date and quantity.
Options contract:
The firm pays a premium for the right-but not the obligation to buy an asset at the price any time before the expiration date of the contract.
Forward contract is good to hedge:
To avoid the currency risk the firm decides to hedge against this risk by “locking in” the exchange rate, it can do so by entering a forward contract with a bank and paying an “insurance” premium. according to the 3-month forward rate.
Financial Hedging of Commodity Risks – option contract. Option contract has two contracts:
Call option and Put option, together they are Straddle option.
Call option:
If the bakery buys a call option of 10,000,000 bushels at the strike price 600 cents. For a premium of $1,260, he gets the right—but not obligation—to buy wheat at the strike price of 600 cents per 5,000 bushels for up to 10,000,000 bushels any time before September 2009. If actual price is below 600 cents per 5,000 bushels between April and September, then the bakery would not exercise its right to buy the wheat at the strike price (which is higher).
Put option:
The bakery buys a put option to protect itself from falling wheat prices. This option gives it the right (but not the obligation) to sell 10,000,000 bushels of wheat at 600 cents per 5,000 bushels before September 2009.
Call Option →
Gives the right to buy at the strike price (profits if the price goes up).
Put Option →
Gives the right to sell at the strike price (profits if the price goes down).
Financial instruments for reducing supplier default include
financial subsidies, factoring and reverse factoring.
Financial subsidies are
when a firm provides financial aid to its supplier directly. It is done to avoid risk. The advantages are that the firm may be able to develop a stronger relationship with the supplier. The disadvantages are that the firm may incur a loss if it goes badly for the supplier.
Factoring is …
when a supplier sell is accounts receivables to a lender at a discount for a quick payment. Accounts receivable (AR) refers to the money a business is owed by its customers for goods or services that have been delivered but not yet paid for. It appears as a current asset on the balance sheet because it represents incoming cash. It is done to transfer the underlying risk. The advantages is that the firm pays the lender at the due date. The disadvantages is that without credit history of the firm, the lender could face high credit risk. Also, according to accounting rules, accounts payable are rendered as debts on the firms balance sheet
Reverse factoring is …
when a lender established a line of credit with a firm in advance to provide quick payment to its supplier at a discount. It is done to transfer the underlying risk. The advantages are that the firm pays the lender at the due date, same as factoring. The disadvantages are that with an upfront audit of the firm’s credit history, the lender can reduce its credit risk. Also, according to accounting rules, accounts payable are rendered as debts on the firms balance sheet.
To effectively manage the risks associated with supply costs and supplier default, a firm needs to examine the following issues:
1) Supplier selection, 2) Supplier contract condition, 3) Capacity planning by the supplier, 4) Production planning (order quantity), 5) Allocation planning (supply differentiation or centralization?)
Knowing that without financial hedging the standard deviation is 0, and with and with forward contract the standard deviation is +/-75, we infer that …
using futures contracts only increases variability risk.
Integrated Operational and Financial Hedging:
A natural hedge combined with a financial hedge + An active operational hedge using allocation flexibility = would yield an expected profit with reduced variance, aka. best outcome
