According to Earrn Forex (2010, p. 1) “hedging is defined as holding two positions at the same time, where the purpose is to offset the losses in the first position by the gains received from the other position.” Companies hold hedges to protect themselves from unpredictable economic conditions. In the modern economic environments companies are experiencing turbulent financial conditions and it is important for managers to come up with policies to protect their assets. This report aims at providing the management of Franklin Commercial Bank with hedging strategies to protect its earnings from changes in economic conditions. Even though the strategy is volatile, the management will have a surety that minimum losses will be made in case a recession strikes the economy.
Hedging strategies are effective given the volatility in the future contracts, interest rate swaps, and derivatives markets in general. Companies use interest rate swaps when exchanging a particular group of cash flows for any other cash flow depending on specific interest rates in the market. Interest rate swaps are financial contracts between two companies such that one company exchanges future interest payments with another company based on a specific principal amounts. Interest rate swaps are used when managing risks of fluctuations in the rate of interest. It is better for a company to obtain low interest rates rather than lose the entire benefits (Coyle, 2001). The management of Franklin Commercial Bank can use interest rate swaps to protect its assets especially when it is predicted that the interest rates will fall in future. This strategy is good when the management expects a looming recession in the near future. Even though the strategy is volatile, the management will have a surety that minimum losses will be made in case a recession strikes the economy.
The management should also consider using future contracts when there are speculations that the market will perform poorly in the near future. Future contracts involve buying and selling specific assets with standard amounts between two companies at a specific day in the future at a price that is agreed upon in the present day. The buyer agrees to posses the assets in the long run while the seller assumes a short-run position (Pirrong, Haddock and Kormendi, 1993). Future contracts will help the Franklin Commercial Bank overcome declining market prices fro assets. By selling assets before the prices drop will help the company overcome huge losses in case a recession strikes the economy.
It is also important for the management to consider using treasury trips to safeguard its assets in case a recession is expected. Treasury strips refer to financial assets with fixed incomes and are sold at specific rates of discounts. There are no interest rates offered for financial strips because their maturity is at par (Johnson, 2004). By the use of this strategy the company expects neither to lose nor to gain from the sale of the assets. It is advisable for a company to break even rather than to make a loss. Global economies are experiencing hard economic times and it is important for managers to secure their assets by adopting treasury trips as one of the ways of reducing risk. This strategy reduces the risk of making a loss in case interest rates for financial assets drop by great margins.
There are alternatives to contractual hedging strategies such as cash sale at harvest, store for later sale, delayed pricing contract, forward contracts, hedging with futures, basis contact and hedging with options. Knowledge about alternative edging strategies helps find out the highest net return for assets. To understand about these alternatives will help the management reduces income variability as well as improves the level of acceptable risk (Idaho Barley Commission, 2010). If the management finds out that the contractual hedging is not working the alternatives can be considered to improve the level of security for the assets of the company. These alternatives are used by companies to protect themselves from turbulent economic conditions because they provide other solutions to minimizing losses in case a recession is experienced.
The management of Franklin Commercial Bank should consider using hedging strategy to minimize the losses which could be incurred in case of a market failure. Even though the strategy is volatile, the management will have a surety that minimum losses will be made in case a recession strikes the economy. Hedging strategies are used when a company speculates a decline in performance of assets due to a decline in the market interest rates.
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