CIPS L5M4 – LO3 Questions and Sample Answers

Question 1: Discuss the different financial objectives of the following organisation types: public
sector, private sector, charity sector (25 points)

A Financial Objective (as opposed to a non-financial objective) is one which is rooted in revenue
generation and cost management. For private sector, the objective will likely be centred on profit
generation and return on investment for the shareholders, owners, or private investors. For Public
Sector, revenue is mostly sourced via tax income (e.g. Council Tax), so the focus will be mainly on
producing good value for taxpayers money. Charity/Third Sector while also not for profit, they will
likely engage in revenue generating activities, but the destination of any surpluses, will be to go
towards helping the charity, fulfil their charitable objective.

Public Sector (Value for Taxpayers Money) - The main aim for Public Sector is value for money due to
limited resources, public sector finance comes through taxes, and it isn’t easy to increase revenue,
but also Public Sector organisations have a moral obligation to the public they serve and are
accountable to the public for what they spend. Public Sector differs from private sector in that it
can’t just decide to increase prices for their services, or sell assets to get money, without going
through extensive Governance, and fully justifying their reasons.

Transparency is another issue; Public Sector are obliged to be transparent about how their money is
spent. The public have the right to know how their tax money is being used and can request
information via a Freedom of Information request. Therefore public sector has to demonstrate Value
for Money as they are held to account on their spending. Achieving Value for Money is a requisite of
law- EU procurement directives and Public Contract Regulations 2015.

Public sector will achieve this by ensuring that best value is achieved, usually through competitive
tendering, or at a minimum request for competitive quotes. E.g., Kent County Council is a public
sector organisation who must complete Fire Risk Assessments in all its buildings, it must demonstrate
that the procurement Fire Risk Assessments represents value for money, so hold a regular
competitive tender process every year to ensure they get competitive prices for this.

Private Sector – Their primary goal is to maximise dividends to shareholders- (this is a long-term
process) and add value to company (share price- net asset value and equity per share). 3 variables
affect shareholder wealth: -

a. Size and value of cashflow,

b. Timing of cashflow,
c. Level of risk associated with cash flow.

Profit maximisation is a short-term goal and wealth maximisation is a long-term goal. Private sector
isn’t held to account in the same way the public and charity sectors are, and don’t have to follow the
same stringent regulations. Therefore, they have more freedom in how they operate and manage
their finances.

E.g., Netflix is a private business and their main aim at the moment is to increase profits for
shareholders, so they have just increased their prices. Despite this angering customers, Netflix is
accountable to its shareholders, and this is the priority of the business.
Charity Sector- generate surplus. Non-profits such as charities and social enterprises aim is to
achieve societal goals such as raising money to find a cure for cancer or protect endangered animals.
They mainly rely on donations from the public and may also receive grants from the government-
therefore they have to be transparent about their spending in the same way that public sector
organisations do. The main aim is to generate a surplus to remain financially viable. They reinvest
the money back into the organisation to ensure survival. Without a surplus the charity would cease
to exist. E.g., WWF is a charity that protects endangered species- it’s priority is to generate enough
money in donations to keep on protecting animals long-term.

While these three different sectors have different financial aims due to the different objectives of the
organisation and will be subject to different levels of accountability, transparency and regulations
that they must follow… all of the organisations will be required to manage their finances responsibly
and effectively. Whether a business if not for profit, or obligated to produce a return for its investors,
it still has to ensure that where possible, that revenue exceeds costs and expenses, so the
organization is not operating at a deficit.

Question 2: Describe 3 ways in which an organisation can encourage a healthy short-term cash
flow by engaging in the effective management of debtors and credit management (25 points)

Cash Flow is the life blood of any organisation, whether it is Public, Private or Third sector, all
businesses need cash to keep operations running, as there will be costs associated with their
premises, staff, and facilities. Cash Flow is more critical to the continue existence of an organisation
than profit or revenue. Healthy cash flow means having money in the bank to pay short-term
liabilities. This is achieved by having robust policies and procedures in place to manage the money
coming in and going out of the business.

Issues can arise when customers buy items from a business on credit, and then do not pay on time.
This causes cash flow problems for the organisation as they have already paid their suppliers. It’s
therefore important that a company has an effective customer credit policy to ensure short-term
cash flow within the organisation.

To meet its financial objectives organisations needs to manage cash flow effectively, there are a
number of ways that a business can do this including: -

1. Putting in place a Customer Credit policy on which customers. This could incorporate.
i) Carrying out independent credit checks and obtaining a customers credit rating prior
to awarding access to credit.
ii) Payment terms – requiring customers to pay within 30 days.
iii) Penalties for late payment – where customer pays late.
iv) Incentives for early payment – where customer pays within a short period.
v) Ensuring strict payment terms and means of settlement are in place contractually.
vi) Monitoring customer debt levels, and/or imposing debt level limits (e.g. Maximum
30000 p.a.),
2. Creditor days - means the average number of days your business takes to pay suppliers. To
ensure a healthy cash flow you need to ensure you have money in the bank when the debt
falls due. A danger of this, is that you pay suppliers but then wait too long for customers to
pay you, leading to a deficit of money in the short-term. One way to mitigate this is by
negotiating creditor days with your supplier- if you can shorten the time between you having
to pay your supplier and receiving money from customers- this will be beneficial for cash
 flow. For example you could ask suppliers if you can pay in arrears rather than in advance.
This can be negotiated for all creditors such as banks and mortgage lenders.
3. Trade credit insurance - provides cover for businesses if customers who owe money for
products or services do not pay their debts. E.g. If a customer defaults and becomes
insolvent then the insurer will pay out up to 80% of the invoice value, there may be an excess
to pay, but it will still help stabilise revenue streams. A main downside is there is a cost to
the insurance.

The effective management of debtors and credit management is important to businesses as it

ensures a healthy short-term cash flow. This is important because an unhealthy cash-flow may lead
to liquidity issues, poor credit rating, bad reputation among suppliers for not paying bills on time,
and ultimately can lead to business failure if they are unable to pay short-term debts."

Question 3: XYZ Limited is a large retail organisation operating in the private sector which is
looking to raise long-term capital. Discuss three long-term financing options which XYZ may use.
(25 points)

Long term capital is distinct from short term capital, which is related to operational day to day
expenditure. Capital expenditure is concerned with investment in longer term growth and will
generally involve the acquisition of longer term assets like Capital Equipment or Buildings for
example or to invest in R&D for a new product or expand into a new market. Long term capital
generally links to the company’s long-term strategic goals.

The main funding sources for Long Term Capital can be Internal or External.

Internal sources of finances could include: -

i) Retained profit,
ii) Sale of assets or stock,
iii) Collection of debt

External sources of finance could include: -

i) Issue of shares,
ii) Loans or mortgages,
iii) Issue of bonds/ debentures,
iv) Sale and leaseback of Company assets.

For the purposes of this response I will look at 3 external sources of finance in more detail; Share
issue, Loans/Mortgages and Sale and Leaseback.

Option 1 - Issue of Shares in the Company: -

A Limited company has the option to issue new shares (a rights issue) in order to raise capital for
investment or expansion.

There are 2 main types of shares, Ordinary shares (which carry voting rights) and preference shares
(which have no voting rights).

Advantages –

1. Is a low-cost way to raise capital funding, and

2. Consequently no debt involved, no requirement to put up assets as security and no
commitment to make repayments
Disadvantages: -

1. It can be an expensive process coordinating a share issue, will involve detailed application,
involvement of expensive lawyers and marketing events which will be costly.
2. Also dilutes ownership and control over the business.

Option 2 – Fixed Term loan/mortgage

This means borrowing money from a bank and paying this back over a long period of time, usually
with interest.

Advantages: -

1. Payable in smaller regularly scheduled amounts, which makes budgeting easier. Predictable
sums.
2. Is not repayable on demand and is payable over a longer period of time.
3. Doesn’t dilute ownership in the same way that a share issue does.
4. Interest may be tax deductible,
5. Readily available, and
6. All business profits are retained, albeit costs will go up.

Disadvantages: –

1. Commitment to regular on-time payments regardless of how much cash the business
generates.
2. Interest rates may vary, making budgeting less sure (as in recent times where interest rates
have increased significantly)
3. May need to secure loan against assets, putting these assets at risk
4. Or may have to pay a high interest rate.

Option 3 – Sale and Lease back.

Under this option a business can sell the beneficial ownership of a significant/high value asset to
raise capital, but lease it back for smaller regular amounts, to improve access to cash for high value
investment purchase.

Advantages

1. Business can raise significant capital without losing use of the asset
2. Lease payments would be in regular/fixed payments, making it easy to budget
3. Not subject to fluctuating and variable interest payments.

Disadvantages: -

1. Loss of a valuable asset, and the asset appreciation opportunity

2. Wiped off the balance sheet of the business, which reduces the overall value of the company
3. Lease payments are a regular burden, which will eat into profits.
There are several long-term financing options XYZ Ltd could use, three of which are discussed above.
Limited e.g. XYZ may explore securing a loan if they are looking to buy a new fixed asset- they’re
likely to get a good interest rate from their bank if they can demonstrate they have a good credit
rating and that there is a sound business case for the purchase (such as the new asset will allow
them to increase sales and revenue). A bank may be less willing to provide a loan if it is to fund a
risky project such as the launch of a new product which isn’t guaranteed to bring in a steady stream
of revenue. In this instance XYZ may be better off looking at raising funds through selling shares.

Question 4: Discuss ways in which an organisation can improve their short-term cash flow (25
points)

Cash Flow can be defined as the available cash flowing through the business that enables it to cover
its operating costs and pay its creditors when short term debt obligations fall due.

There are a variety of ways in which an organisation can access cash to improve its cash flow,
including taking out a loan, selling off assets, collection of debt, optimising stock levels, minimising
debtor days, monitoring overdrafts and making payments on day they’re due (to avoid penalties and
maybe even avail of early payment incentives if they are available).

1. Optimising Stock Levels – you can do this via; robust stock purchase procedures (e.g.
Kanban, or JIT), having an appropriate location and storage of stock (e.g. vendor managed
inventory), accurate and time-bound systems (e.g. MRP/ ERP), effective monitoring of stock
turnover (avoid redundant stock). This helps short-term cash flow because it means money
isn’t being tied up in inventory. Having lots of stock can be detrimental to short term cash
flow because you’ll have paid the supplier, but not yet have received the money from the
customer- meaning your Working Capital is likely to be negative. The quicker you turn over
stock, the quicker money comes into the bank- thus improving short-term cash flow. For
some industries slow movement of stock, also increases the risk of stock becoming
redundant and reduced.

2. Selling of assets- as with stock, money can be tied up in assets (machinery, property etc).
One way to generate money quickly is to sell these off- this will improve short-term cash flow
as it means an extra boost of money coming into the company. An example of this is many
organisations are transitioning to ‘working from home’ models and selling off their office
space. This provides a one-off influx of cash short-term to the business. You could also
mention here 'buy vs hire' decisions and use an example of an organisation who sells off
their fleet of vehicles and hires a courier any time they need to transport something.

3. Collection of debt – this means ensuring customers who have received goods or services pay
for these promptly. Processes could include; chasing unpaid invoices, stopping lines of credit
to customers who haven’t paid yet, or hiring a debt collection company (you could then talk
about each of these in turn). This helps short-term cash flow by bringing in the funds that are
supposed to already be in the bank. A good example here would be a housing rental service
chasing tenants for unpaid rent.

4. Reducing the ‘Operating cycle’ i.e., the time between first payment to manufacturer and
receipt of money from customer (cash conversion cycle) helps to minimise cash flow issues.
 5. Overdraft – this is something you can arrange with your bank that allows your company to
go into minus figures financially for a short period of time. This helps with short-term cash
flow as it provides a safety net when there is a gap between having to pay suppliers and
receiving money from customers. You could talk here about interest rates and the risk of this.

Question 5: A local council is looking at ways it can fund a large construction project they are
planning- the building of a new hospital. Discuss ways in which the Council could fund the project,
and the advantages and disadvantages of this (25 points)

Funding refers to the cash source to enable a project to be carried out. There is an inherent
difference between funding public sector projects such as a hospital vs funding private sector
projects. The public sector generally doesn’t have retained profits in the banks, and accordingly they
can’t easily raise capital through selling shares etc like in the public sector. Therefore, funding a huge
project such as a hospital is much more complex. Some options of how the local council could fund
this are detailed below;

1. Raise the funds themselves – the local council could increase their income through
increasing taxes or through selling off valuable assets to private companies. Advantages –
ensures the council retains control of the project. Disadvantages – this would probably be
very unpopular with local residents. They may lose votes at the next elections or have to deal
with protests.
2. PPP - Public Private Partnerships. There’s no universally agreed definition of what this is but
it is when a public sector organisation such as the local council works in partnership with a
private sector organisation to construct the hospital. Key elements include; large
infrastructure project, which is capital intense, long -term, involves a Special Purpose Vehicle
(a new limited company to finance and execute project- basically a shell company), the
Project Sponsor is not liable for any debts, repayment is from future cash flows, many parties
involved.
a. Advantages: reduces financial risk for the council by bringing in a private sector
partner with construction experience.
b. Disadvantages- the council will be committing themselves to a private sector partner
which means they will likely have to compromise on some of their service aims and
find ways to monetise elements of their service.
3. Private Finance Initiative – this is when the Public sector hires private sector to build the
facility (they invest the capital) and in return they receive regular payments for the life of the
contract, including interest. Common for schools, hospitals, prisons. Started in 1997.
a. Advantages - off-balance sheet financing – debt doesn’t show on the balance sheet-
if the project fails then it won’t hurt the sponsor’s finances, favourable tax treatment
(more allowances/ breaks), favourable finance terms (can improve a project’s credit
risk profile which will obtain more favourable pricing terms), risk sharing, borrower’s
assets are protected (lender is entitled only to repayments from profits, so if there
isn’t any then repayments are not made).
b. Disadvantages – risky if the private company defaults or goes bankrupt. A good
example of this is the PFI for Birmingham and Liverpool hospitals in which the
private sector construction firm Carillion went bust half-way through construction.
Building a hospital is a long-term project so a disadvantage of both a PFI and PPP is that there are
additional risks the local council would need to consider; marketplace changes (e.g. interest rates,
foreign exchange rates), portfolio concentration (private company losses are magnified if there’s
excessive focus on one market), liquidity risks, operational risks (human or operational error),
business risks (STEEPLED factors, disaster recovery, lower than expected returns e.g. M6 toll road).

This is one of the areas in L5M4 I would recommend doing some additional reading. Although the
study guide does cover PFIs and PPPs – it is very theoretical and to answer an essay question about
the subject it’s helpful to have some real-life examples you can draw from. There was a 25 point
question on PPPs asked in March 2021.

Question 6: ABC Ltd is a manufacturing organisation which operates internationally and buys
materials from different countries. Discuss three instruments in foreign exchange that ABC could
use (25 points)

International purchases occur where items purchased are sourced from overseas. Because the
organisation is transacting in a currency other than their own, these types of purchases can be riskier
and more complex, not only does the organisation have to take into account the usual
considerations, but they will also need to consider foreign exchange rates, tariffs, and trade rules etc.
Financial instruments (real or virtual document representing a legal agreement involving any kind of
monetary value, which can be either cash based or derivative based).

Financial instruments which an organisation can use to hedge against this include: -

1. Spot purchase – which is where prices are secured at the prevailing market rate. Spot
Transactions involve the exchange of currencies at the prevailing market rate. This is dictated
by supply and demand. The Spot Market- e.g. Forex – is where foreign exchange or
commodities (e.g. natural gas) can be exchanged and delivered at current market price

2. Derivatives – are where items i.e., commodities are purchased together with derivative
financial products tied to the value of the commodity which hedge the financial risk. Where
prices on a downward trend, earnings on shorting derivative holdings for that commodity
will balance the loss. Derivatives are financial instruments whose value is tied to the
performance of a specific asset like gold. It can be used for risk management, hedging and
speculation.

3. Forward contract, (a type of derivative) is a commitment to buy or sell at an agreed price

now (using the spot price) but the transaction happens at some point in the future. Good
knowledge of market trends would be important, as prices can go up or down. If they go in
your favour (i.e. Shorting in a falling market, or going long in a climbing market) margins can
be made.

4. Futures Contract – (a type of derivative) – like a Forward Contract but it’s bought on a
Currency Exchange rather than over the counter and it’s standardized and trades in minimum
 lot sizes. This stops small businesses being able to access Future Contracts. Also has minimal
allowable price moves called ‘ticks’.

5. Currency Options – (form of hedging) smaller commitment than futures/ forward contracts.
Contract that gives the right to buy/ sell a currency, but there’s no requirement to exercise
the option so you can back out. A premium is payable for the service so this cost could be
lost if you do back out.

6. Currency Swaps – a popular derivative used by governments and multi-nationals- an

agreement to exchange two currencies then swap them back after a specified period of time.
Can also be used for hedging and speculative trading. Rates can be fixed or floating (or one of
each).

In conclusion, there are several financial instruments that ABC Ltd could use to purchase materials
from other countries. These instruments help ABC Ltd navigate the complexity of international
purchases and minimises the organisation’s exposure to risk”.

Question 7: What are three financial risks in exchange rate changes and how might an organisation
overcome these? (25 points)

Exchange rates in terms of International currency (Foreign Exchange) is the relative prices that are
‘charged’ to buy each currency. E.g. It costs approximately 0.86p to buy 1 Euro. Meaning that it will
cost £86 to buy 100 euros. Exchange rates fluctuate continuously on a daily, even hourly basis, so
one can never be absolutely certain of price when buying in an overseas market. Specific financial
risks associated with transacting in foreign markets includes: -

 Transaction risk (exchange rate goes up or down during the transaction)

 Translation risk (an accounting risk- where something is valued incorrectly)
 Economic risk (long-term currency movement)

1. Transaction Risk - The risk is that prices go up and down- so you have no cost certainty. You
could be halfway through a transaction and the exchange rate changes. The risk is to both
buyers and sellers. For example, an organisation based in the UK wants to buy £100 of Euros
and this costs £120. A contract is drawn up the next day, but the price is now £160, because
the exchange rate has changed. The way a company would overcome this risk is to use a
forward or futures contract.
2. Translation Risk – this means an accounting risk relating to ownership of foreign assets,
which have to be converted into a home-country valuation, for reporting purposes. This can
result in paper profits and losses. You can overcome this risk by using ‘consolidation
techniques’ for the firm's financial statements and using effective cost accounting evaluation
procedures. In many cases, translation risk / exposure is recorded in financial statements as
an exchange rate gain (or loss).
3. Economic Risk – this means where the viability of an international supply source can be
affected by long-term currency movements. This means the supply source becomes
uneconomical. The way to overcome this is to identify another source in the long-term.
Question 8: Discuss four factors which may influence supply and demand in foreign exchange (25
points)

Foreign exchange means (trading internationally, often with the buyer and seller using different
currencies and each country having different legislation and economic circumstances). The value of
each country will fluctuate, relative to each other from day to day, and the factors which influence
which direction they fluctuate could include (but are not limited to) : -

1. Interest rates – lower interest rates attract money from abroad and causes appreciation, as
the demand for that currency will be strong. Interest rates are the price you pay to borrow
money, and will be influenced by Central Bank base rates, which are set centrally. Interest
rates are important because they influence demand for borrowed money.

If interest rates are particularly high, demand will fall, because it’s expensive to borrow
money. When they’re low, it’s much cheaper. When people borrow money, they’re usually
using it to invest in big things like a house or a new business. - If a country has a low interest
rate- this will attract foreign investment as it will be cheaper for them to make purchases. An
example of this is the property market in London in recent years. Due to low interest rates in
the UK this has attracted a lot of foreign individuals / businesses to buy property in London.
If interest rates were high, it would cost much more to get a mortgage on a property, so
decreasing demand. When interest rates are high this makes that country’s currency
“expensive” – meaning it appreciates in value and purchasing power (compared to other
foreign currencies). It is likely that the country will therefore experience a growth in imports.
Therefore, demand for foreign imports may increase as they cost less.

2. Economic growth- causes appreciation in the origin currency because markets expect higher
interest rates. Strong economic growth also increases supply, as the economy is growing.
Economic growth means a country is increasing output, meaning that more people are
employed, and more products are being manufactured. The opposite of this is economic
recession where the economy is shrinking, and unemployment is rising. In terms of
international trade, companies want to invest in countries where there is strong economic
growth as it signifies stability and increases the likelihood of business success.

Therefore, strong economic growth leads to an increase in demand to invest in that country
Consequentially if there is negative economic growth (the country is in recession and the
economy is shrinking) companies may see this as riskier and pull their businesses out of that
country. Therefore, negative economic growth can result in a decrease in demand in foreign
exchange.

3. Inflation – Reduces competitiveness of exports. Inflation is the increase in prices over time.
How quickly those prices go up is called the rate of inflation. It is expected that inflation
increases slightly each year, and everyone can cope with the small increase. Hyperinflation
means the price of something increases too quickly and consumers will struggle to afford
items, particularly if inflation increases more quickly than wages, which is exactly what
happened during the cost-of-living crisis in the UK. Where there is high inflation, goods
produced in that country soon become more expensive than similar goods produced in
another country. For example if Argentina experiences high inflation, the cost of buying
something may increase from £100 to £150. If Chile, a neighbouring country doesn’t
 experience the same level of inflation and the price of that item remains at £100,
international buyers will start buying from Chile rather than Argentina. Therefore, high
inflation decreases the demand for the origin country’s item because it’s more expensive to
buy.

4. Confidence in economy/ exchange rate- this drives demand. Where there is a favourable
exchange rate this will increase demand. Where the exchange rate is unfavourable this will
decrease demand. If exchange rate is unfavourable the selling country might have a surplus
of supply. If foreign investors have confidence in a country (i.e. they think it is stable
politically and economically) the demand to invest in that country will increase. If they have
no confidence in the economy they may withdraw businesses from the country, and demand
will decrease.

Factors that influence confidence in economy include; employment levels and growth, GDP
growth / inflation / interest rates, legislation that is being passed, the political party in charge
etc. For example, after the Brexit vote, confidence in the UK economy dropped and some
international organisations took their businesses elsewhere. E.g. Dyson relocated its HQ from
the UK to Hong-Kong.

In conclusion, supply and demand is in a constant state of flux, in international markets, and it is
therefore important that organisations and investors are aware of the political and economic factors
which affect this. Due to the potential for instability and the risks associated with this, some
organizations may utilize financial instruments, such as derivatives (spots, forwards or futures) to
hedge against these risks, particularly where they are buying in large quantities, or the items being
purchased are of strategic importance to them. For example, shorting a commodity in a falling
market will help to compensate for the losses experienced when purchasing the same commodity in
the open market, which hedges against some of the financial risk. There will usually be a margin loss
as there will be commissions to pay, but it will likely be far less that if left to the devices of the open
market.

Question 9: Explain what is meant by a ‘commodity’ (8 points) and why prices of commodities can
be characterised as ‘volatile’ (17points)

A commodity is a raw material / natural product used to manufacture other goods for example oil,
metals, some forms of food such as grain, and livestock. Commodities are split into two categories:
Hard commodity = mined/ extracted e.g. gold – usually storable – price more elastic. Soft commodity
= grown or reared e.g. coffee, beef

As they are naturally sourced, they are vulnerable to elements which organisations will have little or
no control over. For this reason their prices can be extremely volatile. Organisations that are highly
dependent on the supply of a commodity will be particularly affected. Factors which can influence
the price of a commodity include: -

1. Weather, too much rain, untimely snow, too much sun, or changes in the usual timings of
the seasons can all lead to a reduction in yield, where there is a reduction in yield, the price
of the commodity will likely go up. How much by, will depend on the size of the reduction.
Conversely, particularly favourable conditions may lead to an over supply of the commodity,
which will lead to lower priced.
 2. Environmental Factors, which are becoming increasingly common, including conditions
which encourage the proliferation of Pests, or the contamination of land, such as flooding,
these can also lead to a reduction in yield, or in some cases wipe out a harvest, and
dramatically impact output.
3. Political factors e.g. war, as we have seen with the Russian v Ukraine conflict, where the
price of commodities which formerly came out of Ukraine, increased dramatically, virtually
overnight. Worker strikes can also have a detrimental impact on output. Post Brexit, there
was a shortage of overseas workers which led to crops not being picked and rotting in the
ground. A combination of all these factors has helped to create the current cost of living
crisis, being experienced in the UK and other countries around the world.

4. Changes in the price of growing / extracting. This is a current problem in the UK and other
countries around the world, due to a range of external factors such as a reduction in supply
of oil and natural gas, this has led to a sharp increase in the price of petrol and energy, both
of which are heavily relied upon by the industries which extract raw materials, as the cost of
extracting and transporting the commodities has increased. This has also fuelled inflation,
which has led to growing cost of living, which has further fuelled worker unrest/strikes and
placed pressure on industries to increase the wages they pay to their workers. 2023 and
2024 has see an almost continuous cycle of strikes and discontentment across numerous
sectors.

Question 10: What tools are available for buyers to help procure items on the commodities
market? (25 points)

A commodity is a raw material / natural product used to manufacture other goods for example oil,
metals, some forms of food such as grain, and livestock. Commodities are split into two categories:
Hard commodity = mined/ extracted e.g. gold – usually storable – price more elastic. Soft commodity
= grown or reared e.g. coffee, beef

As they are naturally sourced, they are vulnerable to elements which organisations will have little or
no control over. For this reason their prices can be extremely volatile. Organisations that are highly
dependent on the supply of a commodity will be particularly affected.

1. Commodity Indices -Used to value a commodity at a certain point in time. If indices show
prices are rising, this signals demand is exceeding supply, and it would be a trigger for the
organisation to take action to guard against these price rises. Indices are a useful tool for
buyers as it helps them to plan when to make purchases.

They are not affected by high inflation (bonds and shares fall when there’s high inflation but
the value of commodities stays stable. In fact, some commodities like gold become in
demand as it’s seen as a wealth preservation tool.

2. Options/Hedging - This is a tool that protects a buyer from the financial risk of price
volatility. Futures Contracts is a form of hedging. Another example of hedging is the ‘Options
Contracts’.

When using options a fee is payable (immediately) to buy a commodity at an agreed price
(the strike price). If the price goes up you’ve made a saving, if it goes down you are under no
obligation to fulfil the contract. While there is a cost ‘Risk fee’ included, it will be far less than
 if left exposed to the full risk of the market price. Works kind of like an insurance policy and
premium. Options Contracts, however, have a fixed expiry date after which the option cannot
be exercised. Helps to overcome the lack of flexibility of Futures Contracts.

3. Speculation - Speculators can be individuals, or trading firms. It is different to hedging, in

that speculators never have an intention of taking physical delivery of the product. They will
instead, buy futures contracts with a hope that prices increase. They then sell the contract at
a higher price to make a profit – this is called ‘going long’. Alternatively, they can sell a
futures contract where they hope prices will fall which is ‘going short’.

Some speculation helps keep the market liquid, but too much can skew the market (which is
what is happening currently with crypto currency markets). It’s a useful tool buyers can use
to make a profit without having to take physical delivery of a product, which can help them
to hedge against the risk of rising prices, as the loss experienced when buying the
commodity, is balanced against the profit made on speculative purchases of the rising
commodity, less a small fee.

4. Contract for Difference (CFD) – are an agreement between two parties to exchange the
difference between the opening price and closing price of a contract. E.g. you buy a CFD at
£20 – if the price goes up to £25 the broker pays you £5. If the price goes down to £10 you
pay the broker £10.

Popular form of derivative trading which enables the buyer to speculate on rising or falling
prices but doesn’t involve a full sale or purchase of the asset- there’s no physical delivery- it’s
just an agreement to pay each other the change in the price of an underlying asset. CFD’s are
not sold on commodity exchanges however and are only available through brokers.

An advantage of this instrument, is that the contract sizes can be smaller, meaning that the
buyer can hedge risk at a much lower cost. They are regularly used in the most volatile of
markets, e.g. the UK Energy Market.