Figure 236

Risk Profile for a Wheat Buyer wheat

Short-run price changes can drive a business into financial distress even though, in the long run, the business is fundamentally sound. This happens when a firm finds itself with sudden cost increases that it cannot pass on to its customers immediately. A negative cash flow position is created, and the firm may be unable to meet its financial obligations.

For example, wheat crops might be much larger than expected in a particular year because of unusually good growing conditions. At harvest time, wheat prices will be unexpectedly low. By that time, a wheat farmer will have already incurred most of the costs of production. If prices drop too low, revenues from the crop will be insufficient to cover the costs, and financial distress may result.

Short-run financial risk is often called transactions exposure. This name stems from the fact that short-term financial exposure typically arises because a firm must make transactions in the near future at uncertain prices or rates. With our wheat farmer, for example, the crop must be sold at the end of the harvest, but the wheat price is uncertain. Alternatively, a firm may have a bond issue that will mature next year that it will need to replace, but the interest rate that the firm will have to pay is not known.

As we will see, short-run financial risk can be managed in a variety of ways. The opportunities for short-term hedging have grown tremendously in recent years, and firms in the United States are increasingly hedging away transitory price changes.

transactions exposure

Short-run financial risk arising from the need to buy or sell at uncertain prices or rates in the near future.

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