Capital management as a risk control tool reduces the interest rate, currency and operational risks by using derivatives.
Interest rate risk
The risbk arises when a financial position is exposed to movements in interest rates. The change in the position’s value will be magnified by the leverage effect of borrowing or investing with borrowed money.
When companies operate across borders, they may benefit from fluctuations between local currencies leading to an increase in sales (or vice versa). Certain companies will use forward contracts to lock in the current exchange rate. For example, suppose a company has $10 million of revenue coming in 6 months, and they expect to receive €8 million for this trade when the spot value is currently €1 = $1.2. In that case, they can buy €7.3 million today using forward contracts entered into at present exchange rates in six months with an agreed settlement date.
Operational risk is uncertainty surrounding unexpected events resulting from human action or inaction (e.g., Information Technology breakdowns), leading to direct financial loss or reputational damage.
Companies constantly strive to make their operational risks more efficient by hedging their currency and interest rate risks with forwarding contracts.
Company Y can reduce their operational risk by using a forward contract as a form of hedging that locks in the exchange rates and future interest rates for a determined period, thus ensuring it will not face additional losses from unforeseen changes.
Companies need to have an efficient treasury department with enough expertise to buy and sell derivatives regularly to control these risks effectively.
In addition, internal controls must also be implemented so that the treasury department has the authority needed to succeed in its job.
If not, another party needs to be found who is willing and able enough to do the job at hand.
All available methods should reduce operational, interest and currency risks in a company. This way, companies can focus on their core business to achieve a competitive advantage.
The Dutch capital management is an integral part of the budgeting process in the Netherlands. It consists of identifying, monitoring and managing all financial risks that could arise in connection with a business project utilizing formulating realistic forecasts, taking into account all relevant factors which could influence them. The following are ten advantages of this method.
- Capital management ensures sufficient cash available to run the company’s day-to-day activities. Money always needs to be managed since it can become scarce at any time for both individuals and companies alike. It will not result in bankruptcy but relatively slow growth or stagnation if measures are not taken quickly enough to deal with potential shortfalls in regular income streams.
- Insufficient cash flow is not the only reason for bankruptcy. Companies sometimes over-expand, borrowing more than is healthy or failing to adapt to new circumstances, leading to bankruptcy.
- Capital management helps companies monitor their cash flow and identify any problems early on, allowing them time to take corrective actions before becoming insolvent.
- You can use this control mechanism with other budgeting tools like capital budgeting. It also provides an essential instrument for risk management within an organization by allowing companies to prioritize necessary investments and avoid unnecessary ones that might drain resources away from more productive areas of the business. A company should determine how much it costs to borrow money and keep this figure strictly. Only then will it be able to operate successfully.
- Regular forecasting is an essential part of capital management. If the company does not know where it will get its money from in the future, it cannot effectively plan for that time or set aside adequate reserve funds. Therefore, such unfettered forecasting is considered standard practice by many companies and can be very helpful when developing new products or services.
Capital management is often seen as a tool for mitigating these risks, but it consists of more than just using derivatives on its own. It needs to be put into perspective.
Interest rates at which a company lends out or borrows money from its bank, clients or suppliers can vary due to different factors such as Fed’s decisions.
It changes the number of dividends and profits and affects the share price if no action has been taken to reduce this risk by utilizing hedging.
A way of mitigating interest rate risk is through hedging with forwarding contracts or swaps that fix the future exchange rates for a certain period.
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