Price Volatility of Raw Materials Flashcards
In the past, XYZ Co. has used forward contracts effectively to offset price volatility for the purchase of raw materials. The CEO is considering extending this practice for the purchase of additional raw materials.
Write a memo to the CEO describing the factors that should be considered in deciding whether to extend this practice.
-Determine the likelihood of changes in raw material prices occurring and the effect of such changes on the firm’s operating results.
-If the expected impact is negative and significant, then forward contracts or other methods should be used to offset the adverse effects of the expected price increases.
-It would be appropriate to determine the extent to which the increase in raw material prices can be passed on to customers in the form of higher sales prices.
-It also may be appropriate to determine if fixed-price contracts for future purchases can be negotiated with suppliers of the raw materials.
-Consideration should be given to whether it would be economically feasible to acquire and stockpile large quantities of the raw materials when prices are low.
-The risk of noncompliance by a potential counterparty must be considered. Noncompliance is the risk that the other party to the contract will be unable or unwilling to satisfy its obligation at the date of settlement.
What is a forward contract?
-A legal agreement between two parties that specifies the quantity of an asset to be delivered by one party to the other party at a specified future date at a price set at the time the contract is executed.
-Lock in the price of a raw material to be purchased at a future time.
-If the price of the raw material increases during the period of the contract, the contract will gain in value which will offset the increase in the price of the physical purchase of the raw material.
