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Analysis Based on Financial Management and its Derivatives

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Financial Management

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Introduction

Financial management is the process of effective utilization of monetary resources. Present project report will explain the role of management of funds in the organization. This report will discusses dividend policy, financial markets and derivatives for effective and efficient management of collected funds.

Dividend Policy

Dividend policy is the combination of certain guidelines which companies have to follow when they are distributing part of their profits to their shareholders (Deshmukh, Goel. and Howe, 2013). All the organizations generally do not allocate all their earnings as dividend to their investors so this policy assists managers to determine the amount of organizational earnings to be paid to the shareholders. There are various types of dividend policy which have been described hereunder:

Residual Dividend Policy

This policy is based on three key elements that are mentioned below:

  • Target capital structure.
  • Investment opportunity model.
  • Cost of external capital.

Initially, residual-dividend model primarily aims at deciding a target dividend payout ratio. Thereafter, managers determine the equity which will be needed to construct an optimal capital structure (Renneboog and Szilagyi, 2015). Primarily, equity funds will be collected through the use of retained earnings. Management decide optimal capital expenditures level to manage their cost of capital. As per this policy, companies use their total earnings for meeting business operational as-well-as expansion expenditures and if any surplus is left then it will be called as residual which will be use for dividend distribution. Henceforth, it seems to be very useful in capital projects while its disadvantage is fluctuations in business earnings that contribute to bring instability in dividend.

Stable Dividend Policy

This policy overcomes with the limitation of residual dividend model because it helps to maintain stability in dividend. Stability policy says that companies have to provide regular and stable dividend to the investors (Loudermilk, 2012). Henceforth, it reduces uncertainty in the shareholders return. It is adopted by the organizations who attempt to share their earnings with the investors rather than retaining this for future purpose.

NASDAQ international organizations follow stable dividend policy in which managers ensure regular and stable dividend distribution to the shareholders. It is because; managers believe that continuous increase in dividend is not possible because of existing market uncertainties (Engombe, 2014). Therefore, they strive for maintaining balanced payment of investors return which ultimately impact on firm's corporate value.

Hybrid Dividend Policy

It is the combination of both residual and stable dividend policy. As per this model, companies set a minimum dividend which is relatively a small proportion of total business earnings so that managers will be able to maintain it easily (Naser, Nuseibeh and Rashed, 2013). Moreover, they can offer extra dividend to the shareholders if actual incomes exceed the minimum set level. In this policy, companies use and maintain their debt/equity ratio for long term purpose. In present uncertain market, this is highly used approach of international organizations. It is because; cyclical fluctuations have a great impact on business incomes which ultimately affects investors return in the way of dividend (Murto and Terviö, 2014). It allows flexibility in dividend distribution according to the business performance.

Financial Market

It is the place at which people trade for various securities and commodities. Securities involve bonds and stocks while commodities include agricultural products and metals (Segal, Shaliastovich and Yaron, 2015). In this market, large number of buyers and sellers trade their equities, bonds, currency, derivatives and others at lower cost. There are various types of financial markets that have been explained hereunder:

Money Market

It is a market segment at where financial instruments with high liquidity and short maturities are traded. Participants use this market for short-term borrowing and lending purpose (Dieckmann and Plank, 2012). It can vary from many years to a time period of twelve months. For example, following securities can be traded in money market:

  • Negotiable Certificate of Deposits (CDs),
  • Treasury bills,
  • Commercial Papers (CP)
  • bankers acceptance
  • Municipal notes
  • Repurchase agreements (repos)
  • Eurodollars

Thus, this market provides assistance to generate funds for meeting operational expenses.

Capital Market

It deals with long term financial instruments such as long term debt and equity-backed securities. In this market, funds are provided for longer duration of more than one year (Carey and et.al., 2012). It has been classified into two types that are primary and secondary market, explained as below:

Primary Market

It deals with new and fresh securities which provide huge assistance to large companies and government to obtain required funds. They can sale their new issued equity shares and bonds in this market and collect large amount of funds. Sale of fresh issue of equity and bond stock is termed as Initial Public Offering (IPO). It facilitates capital formation in the economy.

Secondary Market

This market segment trades for existing financial securities. After issuing fresh stock in primary market, it will be traded in secondary market (Horowitz, 2014). Various securities such as bonds, options, stock and futures are bought and sold in this market. Here, it is also uses for trading goods and assets. Greater number of investors and speculators transfer their securities to another. It is highly liquid market thus; prefer by investors who do not want to stick their money for longer time period.

Difference between money and capital market

Basis of difference Money market Capital market
Collection of funds Money market helps to gather funds for shorter duration through dealing with highly liquid securities (Money and Capital Market, 2012). Capital market deals with long term securities henceforth; funds can be generated for longer time period.
Financing It assists companies for funding their routine activities. Thus, it can be used to meet out operational expenses. Its purpose is to finance capital expenses such as business expansion.

Difference between primary and secondary market

Basis of difference Primary market Secondary market
Securities It trades with new and fresh securities. It deals with existed securities which are currently trading in the market (Handtke, 2012).
Purchases Investors purchase shares and bonds through issuing companies. Investors purchase securities from other investors rather than issuing organizations.
Dealing It deals through registering securities in the stock exchange. Securities are dealing at Over-the-Counter market (OTC). It refers to the securities that are not traded at stock exchanges.

Financial Derivatives

Derivative is the contract of various assets which will be settled between two or more parties in the future period to manage associated risk. Assets comprise bonds, stocks, commodities, currencies and interest rates. Financial derivatives are the instrument or indicators through which financial risks can be minimized (Hirsa and Neftci, 2013). It can be traded at Over-The-Counter (OTC) market and any stock exchange. It enables parties to trade various financial risks such as currency, equity, price risks, credit risk and interest rate risk. There are number of available financial derivatives which can be used by organizations for controlling and eliminating their financial risk, given as below:

  • Options
  • Futures
  • Swaps
  • Credit derivatives

Options

It is an agreement which gives right and opportunity but not the obligation to the option holder to buy or sell any financial security at a specified future date at prevailing strike price (Chellaboina, Bhat and Shikha, 2014). These rights can be purchased by paying its charges, called premium. There are two types of options that are call and put option, described underneath:

Call option

It gives the holder right to purchase a security at a specified price for a fixed time interval. It is often used by investors if they assume that in future period, share prices may raise.

Put option

Put option is the selling right of option holder to sell an underlying assets at a specified strike price before the expiration date or maturity period. When investors feel that share prices may be fall in future years, then they buy put option to sell their stock at high prices.

Futures

It is the most significant type of derivatives which is generally used in the market. Future contract is an agreement that can be exercised between two parties for sale of assets (Sullivan, 2013). The contract will be settle down at agreed prices and on predetermined date in future. It is highly used by corporations to mitigate or hedge their financial risk at a particular point of time.

Swaps

It is a contract or agreement in which two parties are agreeing for trade loan terms and exchange their associated cash flows to each other. It is greatly used to manage financial risk which can be arising due to fluctuation in interest rates. It is because; high interest rate imposes high financial obligations to the company and vice versa. Under the interest rate swaps, counter-parties will be agreeing to exchange their variable interest rate loan with the fixed interest rate loan (Chance and Brooks, 2015). Thereafter, both the parties will pay towards other person obligations upon mutually agreed rate. Lastly, on the maturity date, principle amount will be again transferred to the original party. It is very risky method because; if one party may fail or goes default of bankruptcy then it will force other party to get back to their original loan (Subrahmanyam, Tang and Wang, 2016).

Credit derivatives

Credit derivatives are the contract between counter-parties allowing them to manage their credit risk. For example; if bank feels that customers are unable to repay their borrowings then bank may use credit derivatives to transfer credit risk to another party. It will provide huge assistance to financial institutions to protect towards foreseen credit risk.

Conclusion

Presented report concluded that dividend policy greatly assist management to manage regular dividend. Financial market helps to collect required funds for different time duration whereas derivatives are the effective tools to hedge financial risk. Thus, it can be concluded that all the techniques help to ensure effective management of funds in the businesses.

References

  • Carey, M. and et.al., 2012. Market institutions, financial market risks, and the financial crisis. Journal of Financial Economics. 104(3). pp. 421-424.
  • Chance, D. and Brooks, R., 2015. Introduction to derivatives and risk management. Cengage Learning.
  • Chellaboina, V., Bhat, S. P. and Shikha, D., 2014. On pricing and optimal hedging of path-dependent financial derivatives. Nonlinear Studies. 21(2).
  • Deshmukh, S., Goel, A. M. and Howe, K. M., 2013. CEO overconfidence and dividend policy. Journal of Financial Intermediation. 22(3). pp. 440-463.
  • Dieckmann, S. and Plank, T., 2012. Default risk of advanced economies: An empirical analysis of credit default swaps during the financial crisis. Review of Finance. 16(4). pp. 903-934.
  • Hirsa, A. and Neftci, S. N., 2013. An introduction to the mathematics of financial derivatives. Academic Press.
  • Horowitz, N., 2014. Art of the deal: Contemporary art in a global financial market. Princeton University Press.
  • Loudermilk, M. S., 2012. Estimation of fractional dependent variables in dynamic panel data models with an application to firm dividend policy. Journal of Business & Economic Statistics.
  • Murto, P. and Terviö, M., 2014. Exit options and dividend policy under liquidity constraints. International Economic Review. 55(1). pp. 197-221.
  • Naser, K., Nuseibeh, R. and Rashed, W., 2013. Managers' perception of dividend policy: Evidence from companies listed on Abu Dhabi Securities Exchange. Issues in Business Management and Economics. 1(1). pp. 1-12.
  • Renneboog, L. and Szilagyi, P. G., 2015. How relevant is dividend policy under low shareholder protection?. Journal of International Financial Markets, Institutions and Money.
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