Hedging Cash Balance Uncertainties

At the end of cash period of cash forecast, the firm expects to be in either a surplus or a deficit position. Let us examine risks and cost that the firm would face if it did not hedge in cash of these cases.That is assume that the firm keeps no cash, near-cash marketable securities , additional borrowing arrangements or any other possible hedge.

Cont……………….

• If the firm is in a period of borrowing at its maximum available borrowing limits and cash flow turn out to be less than expected the firm would be face with a substantial problems. All the solutions to this problems are costly.

• For eg: the firm could raise cash to cover the deficit by obtaining an emergency loan from its bank.however banker are not very receptive to emergency request of this type and this solution could emergency the firm relationship with its bank.

HEDGING METHODS

• Holding a stock of extra cash: 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 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 cash as a hedge and expected a shortage during a period of borrowing or a period of lending. It can cover the deficit simply by drawing funds from its cash account.

Problem

• With holding a stock of extra cash as a hedge is the high cost of this hedging strategy. The firm holds a stock of cash we mean cash held in a non-interest earning chequing account. If the firm instead invested this cash in its operations it would earn a return of at least the firm cost of capital.

Holding a Stock of Near- Cash Assets

• One strategy that is nearly as flexible as holding a stock of cash and that reduces the cost disadvantage of cash is holding a stock of near-cash assets.

• Near- cash assets are securities such as repurchase agreements or nearly matured risk-free securities. Since maturity is very near these assets every carry almost no interest rate risk and are almost as safe as cash. Their use to cover deficit requires that they be sold with attendant transaction costs. Holding near-cash assets can be used to cover deficit whether the firm is in a period of temporary borrowing or lending.

• The cost of near-cash assets as a hedge depends on the return of these investments relative to the firm cost of capital.

Cont……………………….

• For eg: if these instrument yield 6%p.a and the firm’s income is taxed at 33% the after-tax yield is 4%. If the firm cost of capital is 9% the 5% difference is the cost of this hedge.

This method of hedging the firm cuts the cost of the hedge relative to holding cash.large firms commonly invest a substaintial portion of their hedging funds in there assets.

Extra Borrowing Capacity

• One common strategy for funding the firm’s expected financing needs is the establishment of a reserve credit line with a bank or group of bank. In doing this, the firm arranges for the maximum credit line with the bank to expected amount of borrowing.

• This extra credit line, beyond that which the firm is expected to need is a hedge against cash flow uncertainty.

• For eg: suppose that a firm expects to borrow a maximum of rs.1200000. the additional rs.200000 can be used to fund the firm if cash flows turn out to be less than expected. The approach to the hedging problem is fairly convenient and low-cost.

CONT………………

• Any additional inconvenience and expense necessary to apply for the extra amount desired for hedging purpose is a cost of this hedging strategy.

• Additional commitment fee for the hedging portion of the credit line is another cost of this hedge.

• For large firms arranging to borrow large amount the fixed cost of application for the credit line are small relative to the variable costs of the commitment fees. Because these commitment fees are inexpensive relative to the cost of most other hedging strategies the establishment of additional, available borrowing capacity is often the cheapest hedge for large firm.

Investing Temporary Surpluses In Near-Cash Assets• If the yield curve is upsloping the firm has an incentive to invest

surpluses funds for the longest possible time, matching the maturity of the investment made with the surplus funds to the length of time until the funds will be needed.

• However, if there are unexpectedly low cash flow before the maturity of the investment , the firm may be forced to sell before the maturity date. This exposes the firm to interest rate risk.

• One method: risk is to invest the surplus funds in near-cash investment. It incurs two costs which would not have occurred had the maturity of the instrument been matched to the time of future cash needs.

• The firm will obtain less interest income.• The firm will incur more investment transaction costs.

Cont…………….

• For eg: the firm has cash available that will not be needed for the next 50 days. It can invest the cash by purchasing an instrument maturity in 90 days and yielding a yearly interest rate 6.5%.

• Alternatively it can purchase a series of 10 day instruments that currently yield 6%p.a. if the firm chooses to hedge the interest rate risk by using 2 strategy it will lose 0.5% interest.

• Also there are transaction costs incurred when the near-cash assets are liquidated to cover shortages. These transaction cost and interest differentials are the costs of the hedging strategy.

Hedging Strategies In Perspective

• Hedges of the risk implied in the cash forecast is useful.

Different types of hedges

1. Cash is expensive but very flexible.2. Near-cash assets are less expensive but entail transaction costs.3. Excess borrowing will also hedge cash stock out risk but requires

prearrangement and commitment fees. 4. Investing surpluses in near term instruments rather than in longer-

term investment will provide a hedge only in times of surplus.

Its costs are difference in yield between near-term and longer term investments and the cost of additional transactions required.