# The Financial Industry: Hedging

## Hedging

Firms in the financial industry do incur various risks such as liquidity and credit risks. In order to offset the risks they face, organizations can be involved in various investment positions referred to as hedges. Thus, hedging is a term applied in financials to indicate investment positions that an organization can take to offset the risks it faces (Moyer, McGuigan & Kretlow, 2001).

A short hedge is a strategy of investment undertaken by an organization to mitigate the risk already taken by the firm. Under short hedge, a derivative contract is usually undertaken by the firm to reduce the period of a security to hedge against any potential loss resulting from the given risk (Moyer, McGuigan & Kretlow, 2001).

Long-term hedge on the contrary is a situation in which an investor takes a long position in securities so that the future losses resulting from a given risk are avoided. According to Madura (2008), long hedges are important to the organization if the firm knows that it will be able to repurchase the assets later and would like to lock up the price of the asset.

### Calculation

January contract:

• =(5,000,000/1000)*\$14.5 = \$72,500

March contract:

• =(5000000/1000)*\$14.75 = \$ 73,750

The march cost would have been higher:

• = \$73,750-\$72,500
• = \$1,250

The company reduced the risk of high expenditure on fuel cost caused by rising oil prices. This is because by entering into a hedging contract, it was able to save \$ 1,250. Therefore, the hedging strategy is effective.

Hedging costs arise from the expected changes in the price of the assets or resources purchased by the firm. For instance, a firm that aims at reducing the costs of high fuel prices in future may suffer a loss when it enters into a hedge contract at a given price that ends up being higher than the future price of fuel (Madura, 2008).

## International Trade

Factoring is a form of financing for international trade exporters. The method serves several functions such as financing exporters, maintenance of the receivables account of the exporter, collection of any receivable goods and the protection of the exporter against default payments (Choi & Harrigan, 2003).

Strong Foundation: the financing method of factoring enables exporters establish a strong positive credit history through facilitation of payments that are made timely to the suppliers and reduce the amount of debt incurred to creditors. Through such a financial background, the firm would be able to meet obligations as they fall due without difficulties. In addition, the exporter will be able to avoid any upcoming liabilities not warranted (Reif, et al. 1997).

Tax payments: factoring ensures that correct and up to date records of the organization are maintained necessitating payment of taxes and avoiding any inconveniences unpaid tax could cause to the operation of the firm.

Profit maximization: the method reduces the credit costs of suppliers. By taking the advantage of the suppliersâ€™ discounts, the firm can use factoring method to accumulate enough funds for the purchase of raw materials in bulk, earn supplier discounts and reduce costs (Reif, et al. 1997).

The funds made available through the method can enable the organization to embrace any existing opportunities for growth and expansion. According to Reif et al. (1997), the firm is able to operate at its full capacity, buy additional inventory, increase the marketing budget and invest in development activities. Through these activities, the company would be able to grow.

Costs: the factor company is in charge of discounting the cash price of invoices, which is usually a large percentage of the face value of the transaction. These costs may prove high for the company.

Harm to customer relation: it is possible that factoring will cause substantial damage to the company reputation especially in situations where the factoring organization dispenses invoices using poor money collection methods (Reif, et al. 1997).

Image distortion: although it has changed, initial perceptions of factoring were that the firm seeking such services is in financial distress.

Bank loans: banks are good export financiers since they can provide an exporter with enough capital for the business as well as the insurance for the goods.

Export financing programs: different countries have different export financing programs that aim at financing exporters while promoting international business. For instance, the U.S has â€śExport working programsâ€ť that provide capital for exporters.

Importers are other players in the international trade. According to BIC (1985), importers can obtain their finances from two main sources that include bank loans and trade credits.

Bank loans: banks provide various financing options for importers such as overdrafts, terminal loans, hire purchase and discounting of invoices among other options. In spite of the interest costs for the funding options, it is the easiest means of funding an investment for an importer (BIC, 1985).

Trade Credit: this can be a cheap source of funding for an importer although some importing companies may not be in a position to negotiate trade credit terms independently. An importer can use documents such as promissory notes and bills of exchange in order to be granted a trade credit.

This is trade in which paid for goods and services are exchanged for other goods and services.

## References

BIC, (1985) Export financing: a handbook of sources and techniques. Michigan, Financial Executives Research Foundation.

Choi, E. & Harrigan, J. (2003) Handbook of international trade, Volume 1. Hoboken, NJ: Willey Blackwell.

Madura, J. (2008) International Financial Management. 9 Ed. Cengage Learning.

Moyer, C., McGuigan, R. & Kretlow, J. (2001) Contemporary Financial Management, 8th Edition. OH: Cincinnati: South-Western College Publishing.

Reif, J. et al. (1997) Services–the export of the 21st century: a guidebook for US service exporters. California, CA: World Trade Press.

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