topic 3 part 2 finance Flashcards
starts with ethical issues related to financial reports (reporting practices)
reporting practices as ethical issue related to financial reports(?)
- stakeholders entitled to access bus financial info
- SHs in private company y legally entitled to receive financial reports annually even if sompany small bus & SHs family members
- if pretend profit lower than it should, attempt to defraud ATO which is illegal and unethical - if bus wants to raise additional capital from existing SHs/from bank, understating profit more diff to persuade sources of finance to lend
- if bus decides to sell bus as concern, purchaser needs see financial reports for years prior sale
- under/overstating value of assets counterproductive when potential buyer scrutinise reports
examples of bus inflows & outflows of cash
INFLOWS:
- sales
- cash payment for accs receivable
- sales of assets
- interest received from investments,, etc
OUTFLOWS:
- payments to suppliers (raw materials, finished goods)
- interest on loans/loan repayments
- operating expenses (wages, salaries, raw materiasl, finished goods)
- purchasing assets
forecast
cash flow statements
movement of cash receipts & cash payments resulting from (only cash) transactions over PIT,
- identify trends & predict change
- prepare forecast to estimate amt money expect to flow in & out, usually covers next year but can (week, month)
- caash flow forecast manage cash flow easier, owners can predict surpluses/shrtages of cash to make informed decisions to see likely effect on cash flow
overdrafts??
cash flow management strats (3)
temporary cash shortfalls use overdrafts (from banks to overdraw ACC to limit & pay IRs but if longer period, risk insolvency/bankruptcy)
- need to ensure cash available to make payments when due to:
- ATO
- SUPPLIERS FOR ACCS PAYABLE
- EMPLOYEES (wages)
- owners & SHs for profits & dividends
- bansk & FIs for interest on loans/overdrafts & leasing payments
- distribution of payments
- discunts for early payment
- factoring
5 most common reasons SMEs experience cash flow problems
- slow paying debtors
- rapid/unsustainable growth
- failure to perform credit checks on debtors
- tightened lending restrictions more diff to get credit
- seasonality (companies that make/sell seasonal goods often run out of funds certain times of year)
distribution of payments as common cash flow management strat
spread payments evenly throughout the year rather than making lump sum payments so large expenses don’t occur at same time & prevent cash shortfalls
- more equal cash outflow each month > large outflows in some months
- forecast cash flow to identify periods potential shortfalls & surpluses
discounts for early payment as cash flow management strat
offer debtors discount for early payment
- when bus offers customers % reduction on total invoice value when its settled before payment deadline
- most effective when targeted at debtrs who owe largest amts over financial year
- beneficial for debtors who able to save money and improvve cash flow & bus cash flow status
adv & disadv of offering discounts for early payment
ADV
- reduce risk of late payment & associated costs (late/unpaid invoices cost bus’ in debt interest, admin costs, waste time chasing payment
- ^ custoemr loyalty & improve customer relationships, discount incentive to choose bus over competitors
- improves owrking capital & provides extra liqudiity
DISADV
- decrease profit margins as discount offered paid directly from profits
- need to track cash flows carefully otheriwse may mistakenly give discounts to custmers who claim they’re paying sooner but arent. & recovering underpayment affect relationship w/ customer
- no guarantee customers consistent
- harder to forecast cash flow
factoring as a cash flow management strat
selling accs receivable for discounted price to finance/specialiset factoring company
* bus saves costs involved following up unpaid accs & collecting debts
* growing in popularity to improve working capital
adv & disadv of factoring
ADV
- immediate cash injection (funds in acc within 24 hrs to improve working capital)
- isnt a loan so bus wont take debt/pay interest
- availability depends more on customers’ credit ratings than bus’ so firms with bad credit can access factoring
DISADV
- reduce bus’ profit margin on each invoice they sell
- can be more expensive than other ST finance
- damage bus relationship w/ customers as no longer deal exclusively w/ bus esp if factor uses aggressive colection mathods
- indicate to customers bus has cash flow problems, more cautious of dealing with em
invoice discounting (very similar to factoring)
manage cash flow but bus chases own payments in usual way so customers arent aware of arrangement
* factoring, finance compayn responsible collect debts owed
working capital management (strat)
funds available for the ST financial commitments of a business (liquidity)
- net WC: CA-CL
- WC ratio: CA/CL
- must balance betw using funds tocreate profits & holding sufficient funds to cover payments
short term liquidity importance
means bus can take adv of profit opp when they arise, meet ST financial obligations, pay creditors on time to claim discounts, pay tax & meet payments on loans & overdrafts
- lack = sell NC assets, including LT investments (property, equip) to raise cash –> LT reduce profitability for owners & SHs
why does a business need sufficient liquidity
so cash available/current assets can be converted to cash to pay debts
- creditors guarantee their accs will be paid
- fail to pay debtso n time alienate creditors & suppliers who experience extra debt collection costs & lose confidence in bus
working capital, net working capital, working capitalcycle
funds available for **ST finanical commitments
**
current assets - current liabilities
- funds needed for day to day operations of bus to produce profits & provide cash for ST liquidity
length of time takes bus to convert net current assets & current liabilities into cash (time takes when bus purchases inventory to resell/raw materials if manuf products to when receive cash once sold
what happens if there insufficient & excess working capital
bus failure if poorly managed
- means cahs shortages/liquidity problems & forced to ^ debt/new sources of finance/sell NC assets
- EXCESS means assets earn < cost to finance them
profitable business difficulty with cash because
many bus profitable but have cash flow problem bc profit doesnt equal cash (vice versa) bc they have a workign capital problem
what does it mean when the current (working capital) ratio is 2:1, high vs low
current assets (2) : current liabilities (1)
- within next 12 months, 2x amt assets need to be sold to generate cash & meet ST debts of business for same period
- acceptable but ratios depend on industry, type bus, efficienct to convert CA into cash, relations w/ creditors & banks that (sources of cash)
HIGH = invested too much in CA bringing small return
- reduce profitability as bus reduce risk not being able to pay debts by having higher ratio
LOW = bus more profitable if investing its resources in LT assets & generating more profits but risk unable to pay CL
3 types of strats
control of current assets in working capital maangement
- cash
- accs receievable
- inventories
- constantly changing as inventories sold, cash paid out, payments received
- require planning & constant monitoring
- excess stock & lack control over accs receivable –> ^unused assets –> ^ costs & liquidity problems (excess cash is cost if unused)
- management needs to select optimal amt each current assetheld & raising finance required to fund assets
- WC must be susficient to maintain liquidity & access to credit (overdraft) to meet unexpected circumstancs
cash in control of current assets (working cpaital management)
careful of lvls cash held
- ensures bus can pay debts, repay loans, pay accs in ST & survival in LT
- cash reserves to take adv of investment opp
- forecast timing of cahs receipts, cash payments & asset purchases avoids cash shortages/excess
- cash flow shortages from unforeseen expenses may borrow money –> incur **interest ** costs
- try keep cash balances at minimum & hold marketable securities (investments that can easily be bought, sold, or traded on public exchanges, highly liquid) as reservces of liquidity guard against sudden shortages/disruptions to cahs flow
(accounts) receivable (s) in controlling current assets for working capital management
Amts owed to business by its debtors that is expected to be received in a relatively short time
- outstanding invoices/payments bus has - money bus owed by customers
- discounts for early payments, late fee policy
- send invoices & reminders regularly (fortnight)
- factoring
- credit rating check before allowing large credit sales
- make sale (delivered g/s to customer) but customer owes payment still,
- collecting vital to ensure cash flow & managing working capital, ensure timing allows bus to maintain adequate cash resources
- quicker debtors pay, better cash position
procedures for managing accs receivable
- specifying reaonsable period for payment of accs & set credit terms (typical payment cycle 30-90 days) longer payment term extends more credit to customers & ST bus paid faster)
- factoring
- offer bonuses/rewards for early payment (discounts, free shipping, loyalty programs) to encourage pay on time
- late payment fees encourage prompt payments
- preapre debtors report (list customers (debtors) that owe bus money, how much owe, how long payment overdue easy to identify slow payers so dont issue them w/ additional credit until paid outstanding debts)
- send customers’ statements monthly at same time each month so debtors know when to expect accounts
DISADV OF OPERATING TIGHT CREDIT CONTROL policy
possibility customers may choose to byt from other firms
afterpay affecting accs receivable
digital service possible for customers to buy sometihng now and pay off in fortnightly instalments
- customers get product straight away and if meet regular repayments wont be charged interest but missing one $10 fee
inventories in controlling current assets under working capital managemnet
monitor lvls prevnt excess/shortage stock
- use JIT
- some bus hold large inventories to ensure dont run out stock but can be huge cost bc take storage space long time and miss opp to invest money other places
- obsolescent after PIT, esp perishable goods eg. food,
- shortage –> lose customers
- ensure intenvtory turnover sufficeint tp gemerate cash to pay suppliers on time so they’re willing to give credit in ffuture
processes of financial management (syllabus)
planning & implementing (financial needs, budgets, record systems, financial risks, financial controls)
- debt & equity finance
- match terms & source of finance to purpose
monitoring & controlling
- cash flow statement
- incoem statement
- balance sheet
financial ratios
- (liquidity: current,
- gearing: debt to equity,
- profitability: gross profit, net profit,
- efficiency: expense, accs receievable turnover,
- comparative ratio analysis (over diff time periods, against standards, with similar bus)
limitations of financial reports
ethical issues in financial reports
financial management strats (syllabus)
- cash flow management
- cash flow statements
- distribution of payments
- discounts for early payment
- factoring
- working capital management
- control CA (cash, accs receivable, inventory)
- control CL (accs payable, loans, overdrafts)
- strats (leasing, sale & lease back)
- profitability management
- cost controls (fixed, variable, cost centres, expense minimisation)
- revenue controls (marketing objectives)
- global financial management
- ERs, IRs,
- methods international payment (payment in advance, LOE, clean payment, BOE)
- hedging, derivatives
what does the rate ot inventory/stock turnover differ depdning on
type of bus
eg. fruit merchange has high turnover & pays inventory close to time of sale but vehicle dealer slower stock turnover and pays for inventory before sale made
invenstory control
system to ensure costs maintaining inventory of materials kept minimum
- minimise costs by not allowing materials to remain idle and ensure available for production when needed
- control (Physical) inventory & through (accounting) control eg. using inventory recording system
- many use bar coding & computerised stock records
- computerisation minimsie loss/theft stock w/ precise up to date info abt stock lvls
- signals alert management when time to order new materials + how much to order
- conduct stocktakes, physcially count stock and ocmpare against expected to be available &diff means stock control problems
define + 3 of the CL’s
control current liabilities in working capital maangement (3)
LOA
ST debts expected to be repaid within 12 months
- accs payable
- loans
- overdraft
(accs) payable(S) in controlling current liabilities under WC management what happens if fail to?
amts bus owes to creditors who need to be paid in relatively short time
- monitor interest-free credit periods (pay at later scheduled date) to avoid late fee charges (timing –> maintain adequate cash resources)
- take adv of early payment discounts (ensure **trade credit **extended to bus in future)
- improve credit rating to reduce borrowing cost associated w/ risk
- extend terms for payments offered by established suppliers w/o extra penalty
- bus can negotiate reduced prices if credit cards used
- need record system to accurately trace accs payable to ensure know how much owe each supplier & make payments on time
- fail to properly manage & track payables –> late payment penalties, damage supplier relations
(Control CL in WCM)
what does controlling accounts payable involve
suppliers & their credit policies
- early payment discounts
- interest free credit periods to avoid late fee charges
- extend terms for payments sometimes offered by established suppliers w/o interest/penalty
- improve credit rating to reduce borrowing cost (Risk)?
what other financing plans should owners use when controlling accs payable?
investigate with suppliers eg. floor plan & consignment finance
-
slow stock turnover often use 1. floor plan/floor stock finance so suppliers agree to provide for PIT before payment due
2. consignment financing where goods supplied for particular PIT and payment generally not required until goods sold - goods supplied can be returned if not sold within designated period
loans when controlling current liabilities under working capital management
may need to borrow funds in ST to purchase assets, unforeseen circumstances,
- prepare cash budgets & cash flow statements
- est costs, IRs & ongoing charges monitored to minimise costs
- ST loans expensive form borrowing should minimise use
- controlling loans = investigating alt sources of funds from diff banks & FIs
- manySMEs use bank loan to ^WC, buy stock, equip & machinery, smooth seasonal CF, pay staff, advertising & marketing,
overdrafts when controlling current liabilities in working capital management
convenient, relatively cheap form of ST borrowing for business to overcome temporary cash shortages (bank allows you to access funds beyond your account’s balance, up to a certain limit)
- can use to overcome cash shortfalls forecasted by cash budget
- differ betw banks but generally overdraw acc to limtied amt (charge fees daily/monthly depending on bank policy
- carefully monitor bank charges bc vary depending on type overdraft
- banks can demand immediate repayment of overdraft (rare) esp if bus has good record
- bus should have policy for using & managing overdrafts & monitor budgets on daily/weekly basis to control cash supplies
in addition to overdrafts & loans, what do many SMEs use to assist with working capital?
use credit cards, rely on personal finance options to ease cash flow problems
- prefer over other forms cash flow management & undertaking cash flow forecasts or offering suppliers discounts for early payments??
- many take out bank loans/extend overdrafts to cover upfornt costs paying staff (dont use JobKeeper casue cover staff wages even if firm no operating)
leasing as strat to manage working capital & advantages of leasing
- maintain more working capital to invest in other opps
- can update capital machinery more often
payment of money to use equip owned by another party
- contract betw lessor (owner of asset) & lessee (user of asset) that lets lessee rent asset for PIT exchange for periodic payments
adv
- cash outflows (payments) related to it spread over several years than one-off large cash outflow if bus purchased asset outright, imporivng working capital
- considered as operating expenses –> tax deductible
- flexibility to upgrade to new, better assets w/o making large cash outlay purchasing new equip once assets outdated
- help cash flow forecasting & budgeting (fixed payments for specified time)
- bus will know what payments will be for duration of lease & repayments wont fluctuate over time like other forms borrowing
common strategies
sale & lease-back as strat for managing working capital
selling owned asset to lessor & leasing asset back through fixed payments for specified PIT
- gives immediate source of finance w/o incurring new debt
- only pay fraction of asset value to lease it back from lessor
- lessor retained ownership of asset for agreement
- biggest adv helps improve liquidity since bus received large cash injection from sale of asset which can be used as working capital if experiencing cash shortfall
- bus continues benefit from using asset
- shares many adv of leasing
profitability management
control both bus costs & revenue
- accurate, up to date financial data & reports needed
- most bus idecisions influenced by costs associated with it, examine carefully before implementing
- REVENUE controls (sales obj & mix, pricing strats) , EXPENSE minimisation, COST controls (cost centres, in/direct, fixed/variable)
fixed & variable costs in costs controls under profitability management
FIXED COSTS: not dependent on lvl operating activities (insurance, rent) of bus,
- dont change when lvl activity changes & paid regardless what happens to bus (salary, depreciation, insurance, lease) but can change eg. new premises, leasing costs increased then fixed
VARIABLE COSTS: vary in direct relation(proportionally) to lvls production/operating activities (labour, energy, materials)
- changes in volume of activitiy need to be managed and csts compared with budgets, standards, previous periods ensure minimised & provfits maximised
cost centres in cost controls under profitability management
certain departments, sections of bus costs directly attributed (incur costs)
- establish CC –> review spending of each cost centre & cut costs by reducing CC’s allocation of funds
- treat as separate unit can **measure how much spending on function yrly **
- management can measure, budget, control costs for each function
- utilise resources more efficiently w/ better understanding howthey’re used
- track & monitoring expenses using cost centres greater controlof total costs
- can have several cost centres within 1 deparment eg. manuf each assmelby line cost centre also IT deparment, accounting dpearmtnet
examples of ways
expense minimisation as cost control under profitability management
examine all activities & decide where costs in production/provision of service can be cut (w/o compromising quality, remain competitive)
- balance cost savings & quality must determine which area/s acitivties
- many reduce costs and pass savings on to customers without significantly impacting value of product to customers
- lower profits if high expenses bc they consume valuable resources
- eg. EoS purchase products in bulk, short delivery routes, small store sizes, minimise staff nos., limited opening hrs (reduce staffing & utility costs), aka cost leadership, JIT inventory system, capital-labour substitution, training (labour productivity), outsource, early payment discount
3 ways
revenue controls
^ rev to ^ profits (sales/fees for services/commission)
- need clear abt marketing obj: including sales obj, sales mix, pricing policy
- budgets & cost-volume-profit analysis tools used to control revenue
- sales objectives
- sales mix
- pricing strats
marketing obj in controlling revenue under profitability management (sales obj, sales mix, pricing policy)
^ sales
SALES OBJECTIVES
- links betw marketng plan & financial plan
- sales targets to max sales, ^ stock turnover –> max rev
- must cover fixed & variable costs and result in profit
- cost-volume-profit analysis can determine lvl revenue suff to cover costs to break even & predict effect on profit of changes in lvl activity, prices, costs
SALES MIX
- range g&s sold (sell to large retail markets –> develop broad sales mix to appeal to widest market possible while reducing riskbc its variety. consider disecos of scale when developing new product lines)
- changes to sales mix can affect revenue, control by maintaining focus on customer base (msot of rev) before diversifying/extending product ranges/ceasing production on certain lines
- research to identify portential effects of sales mix changes before making decisions
PRICING POLICY
- should balance sales w/ profits & costs (low prices encourage sales & market penetration but need to cover LT costs)
- affects revenue –> working capital
- closely monitor & control pricing decisions
- overprice wont attract buyers, underprice higher sales can result in cash shortfalls & low profits
factors that influence pricing (policy) as marketing ob
- costs producing g/s (materials, labour, overheads)
- prices charged by competitors
- S< goals (eg. improve market share in 5 yrs reduce prices)
- image/lvl quality ppl associate w/ g/s
- gvt policies
risks in global financial transactions
many large FIs offer range of services to facilitate financial management of global bus
- currency fluctuations/ERs, IRs, international payment methods, hedging, derivatives risks for F managers (ext bus enviro, not significantly controlled by bus) but can use strats to minimise neg effects
- financial risks of global expansion > domestic
exchange rates in global financial manachement
value of 1 currency expressed in terms of another
c’s have own currency for domestic purposes - international transactions, 1 currency convert to nother trrhrough foreign exchange market, determines value of one currency (expressed in terms of) relative to another
- most exporters expect to be paid in own currency
- appreciation, every unit AUD converted into more foreign currency –> benefit AUS importer but reduce int competitiveness of AUS exports
- depreciation pay more AUD for same amt imports
- major risk linked to int trade & investment flow
- forex dealers constantly buy & sell each other’s currency, price/value each c’s currency established aka exchange rate
- foreign exchange rate ratio of one currency to another, shows how much a unit of 1 currency worth in terms of another
effects of currency fluctuations
ERs flucturate due to variations in demadn & supply
- risk for global business - when expenses transferred betw nations, exchange rate inc/dec value
- sig impact profitability of global bus, ability to meet financial objs,
- appreciation raises value of AUD in terms of foreign currencies
- each unit of foreign currency buys fewer AUD
- 1 AUD buys more foreign currency
- exports more expensive on international markets but import prices fall
-
reduce international competitiveness of AUS exporting businesses
2. depreciation lowers price AUD in terms of foreign currencies, each unti of foreng currency buys more AUD,m exports cheaper, prices imports rise - improve international competitiveness of AUS exporting businesses
interest rates in global financial management eg. relocate offshore, expand domestic production facilities to increase direct exporting raise finance
global bus can borrow moeny from FIs in AUS/ borrow money from finanical markets overseas
- AUS IRs usually above other countries, AUS bus borrow finance from overseas source gain adv lower IRs, reduce borrowing costs (if dom IRs rise/same whn overseas fall,)
- risk ER movements - adverse currency fluctuations
- LT ‘cheap’ IRs can cost more
- major impact on profitability if borrowed moeny from finance markets overseas (risk ER depreciation)
4 methods of international payment in global financial management (2 problems and 1 solution for them)
not being paid big risk for exporting bus’
- complicated payment when dealing w/ someone never seen, speaks another language, uses diff monetary & legal system,
- major concern for exporter is if products shipped before payment receied, no guarantee importer will pay
- importer concerned if payment sent before products received, no guarantee exporter will send products
- to SOLVE, use 3rd party both trust eg. bank as intermediary
- payment in advance
- letter of credit
- clean payment (/open acc)
- bill of exchange
option depends on bus assessment of importer’s ability to pay (creditworthiness), each method varies risk esp when credit payments involved
payment in advance as method of international apyment
(importer sends payment before goods sent, exporter receive)
- exporter no risk, used if other party is a subsidiarybuyer’s credit worthiness uncertain
- very few importers agree to terms bc exposes msot risk for them with no guarantee they’ll receive what they ordered
letter of credit as method of international payment
document importer requests from their bank guaranteeing payment of goods will be transferred to exporter when conditions met
- sometimes exporters require importer to have letter of credit confirmed by secure bank to ensure payment wil be received
- once bank makes commitment, cant withdraw
- if buyer(importer) cant make payment, bank cover purchase and only issue if know buyer will pay
- some banks require buyers to deposit/enough moeny to cover payment otherwise allow buyers to use a line of credit
- popular with exporters bc relies on bank > importer (low risk for exporter, high risk for importer, risk for bank issuing LOC)
bill of exchange as method of international payment 2 types
document drawn up by exporter (drawer) demanding payment from importer (drawee) at specified time (low risk for both)
- exporter can maintain control over goods until payment made/guaranteed
- risk of non/payment delays when using this always greater than letter of credit
- docs agaisnt acceptance (risk importer delay payment/not pay at all) expose exporter greater risk than docs agaisnt payment (risk importer may not collect docs/pay for goods)
- Document (billl) against payment
- exporter shifps goods and submits BOE to their bank, who forwards docs to importer’s bank. importer receieves docs when making payment
- importer can collect goods AFTER paying
- exporter draws up a BOE with importer’s bank with docs allowing importer to collect goods if they pay the BOE
- importer’s bank hands over docs after payment made & transfers funds to exporter’s bank
- exporter instructs importer’s bank to hand over shipping and BOE to importer only if they pay BOE
- favourable for exporter bc guarantees payment before importer receieves goods
- Document (bill) agaisnt acceptance
- exporter submits BOE to their bank, sends to importer’s bank but importer just ACCEPT BOE (promise to pay on future date)
- importer can collect goods BEFORE paying
- exporter instructs importer’s bank to hand over shipping & BOE to importer only if they accept BOE
- importer only sign acceptance of goods & terms of BOE to receive docs –> can pay for goods at later date
- exporter risks importer defaults on payment
clean payment (open acc) as method of international payment
exporter ships goods directly to importer before payment received
- importer doesn’t send payment until after receive goods, which usually shipped with invoice requesting payment at certain time after delivery (30, 60 or 90 days)
- time exporter gives buyer to pay for goods is credit term
- when exporter confident that importer will pay by agreed time
- super risky for exporters but very advantageous options for importer
hedging in global financial management (2)
minimising risk of currency fluctuations (ER) to reduce lvl uncertainty w/ international financial transactions
- spot exchange transaction when 2 parties agree to **exchange currency & finalise deal immediately **
- spot exchange rate value of one currency in another currency on certain day
-
ERs constantly change, currency fluctuations can increase costs and reduce profits
1. natural hedging
2. financial instrument hedging (derivatives/financial hedging)
natural hedging
structuring operations so natural flow of revenues and expenses offsets risks
- arrange import payments & export receipts denominated in same foreign currency so losses from movement in ER offset by gains from the other
- marketing starts to reduce price sensitivity of exports
- import & export contracts denom in AUD to transfer risk to buyer (Importer)
- establishing offshore subsidiaries
financial instrument (derivatives) hedging
4 types
financial contract based on asset/share/currency’s future market value
- FORWARD EXCHANGE CONTRACT: exchange 1 currency for another at agreed ER on future date (30, 90, 180 days) –> eliminate risk ER volatility but cost unable take adv favourable ER movements
- FUTURE CONTRACT made on trading floor of future exchange to buy/sell commodities at future date for specified price set in present, prevent unfavourable commodity price fluctuation bc traders certain of price they pay/receive
- OPTION CONTRACT: trader right not obligation to buy/sell assets at price agreed in present over PIT. holders protected from unfavourable ER fluctuations but have opp if ER movements favourable
- CURRENCY SWAP:: exchange curency in the spot market w/ agreement to reverse transaction in future
derivatives + 3 main derivatives available for exporters `
simple financial instrumetns can be used to lessen exporting risks of currency fluctuations
- fixed IR on loan, hard to predict so can lock in rate on loan to protect themselves against future IR rises
- can plan finances bc know exactly how much repaying
- wont benefit from falling IRs
- forward exchange contracts
- option contracts
- swap contracts
forward exchange contract
contract to exchange one currency for another currency at agreed ER on future date (30, 90, 180 days)
- eliminates risk associated with ER volatility but unable take adv favourable ER movements
options contract
gives buyer a(option holder) right not obligation to buy/sell foreign currency some time in future
- protected from unfavourable exchagne rate flucturations & maintain opp for gain if exhcange rate movemetns favourable
financial hedging
currency swap contract
agreement to exchange currency in the spot market & reverse transaction in future
- exporter receieved foreign currency from importer and importer receieves home currency, agree to swap at future date w/ predetermined ER
- also use when need to raise finance in currency issued by country not well known and forced to pay higher IR than available to better known borrower/local bus
- main adv allows bus to alter its exposure to exchange fluctations wuthout discarding original transaction
- despite being reputable bus w/ good credit rating if not known in foreign c.
swap contract hypothetical
if finds broker/bank, Japanese bus wants AUD could swap: AUS bus borrow AUD in Aus (well known, can arrange loan at cheaper IRs), Japanese bus borrow yen in Japan same reason. agree to swap currencies & repay each others loan (AUS bus repay japanese yen loan)
