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.