Eurocurrency is the term used to refer to deposits that are made in banks that are located outside the confines of the country that has issued the currency denomination. For instance, a deposit can be made using Canadian dollars into a bank in South Korea (Weiss, 2007) .They are also called Euro dollar deposits. The key point here is the difference in the location of the bank and the denomination used. One mistake people make concerning the issue of Eurocurrency is to think that its operations are confined in Europe. The term is just generic and can refer to any such kind of transaction done anywhere in the world without necessarily involving Europe (Weiss, 2007). However, the counties can change the term in-order to localize it such that you find the Japanese calling it the European while the British will call it the euro sterling. This means that it can be currency specific but the bottom line is that all those term will refer to the same thing.
Eurocurrency deposits usually attract higher rates than in domestic deposits because of several reasons (Mulhearn, 2008). One of the reasons is that the countries never impose a requirement for reserve on the operations of foreign currency. This means that a bank can lend a higher deposit proportion if it wants to improve its profit margins by taking advantage of the interest rates (Weiss, 2007). Secondly, the domestic rates are insured and the cost is normally not as risky because it is being borne by the person making the deposits. In the Eurocurrency case, the investors usually call for higher rates due to the high risk involved in transact. Most common forms of deposits are made using the Dollar of the United States of America because it is the international currency that is used in the international business (McCormick, 2004). In the US such deposits are not subject to Federal regulations meaning that they are not controlled by the jurisdictions of the Federal Reserve Bank. Eurocurrency in Asian banks is referred to as Europe dollar. It is very common for Asian companies to invoice each other using the dollar of the United States of America if the proceeds are held up by domestic banks (Weiss, 2007).
Another form of Eurocurrency is the petrodollars that refer to money earned through the international sale of petroleum and lands into the Eurocurrency accounts (Mulhearn, 2008). For example, Venezuela and Iran have started selling oil in form of Euro just like Saddam Hussein did before the US invaded Iraq some year ago. The use of Eurocurrency by these countries has created what is referred to as petro-market.
Factors That Led to the Development of Eurocurrency
After the Second World War, the amount of the US dollars that were outside their country of origin increased in staggering proportions because of the Marshall Plan (Mulhearn, 2008). The Marshall Plan was a program for the economic reconstruction of West European countries after the war. The money that was given in the initial phase of the plan was transferred to the respective governments of Europe and they were administered commonly by the governments. There were ECA envoys in each capital city in Europe to give advice about the money. The plan money was used to buy goods from the US. The European Nations had already run out of money and their reserves were empty because of the over involvement in the war (Mulhearn, 2008). Their only hope was the marshal plan aid. There was also an establishment of the counterpart funds to inform of the domestic currency of every European state. Because of the state of the European economies at that time, the United States did not have any competition in the international business and the marshal plan increased its influence and that of the dollar (McCormick, 2004). The large amount of the US dollars outside US as a result of the plan was not healthy for international business and after the Korean war, there were fears of fiscal reprisals by the enemies of the united states and this would have affected all the dollars that were lying out of the jurisdiction of the federal reserve bank of the US (Mulhearn, 2008).
A way of safeguarding that money had to be created but this did not come out until Russia faced a similar situation some years later. There were also very many imports taken into the US because the US had grown to become that largest consumer after the war (Mulhearn, 2008). This means that there were enormous amount of its dollars that were being held by banks outside the United Sates of America. Some of these banks were in countries like the Union of Soviet Socialist Republic which had been granted through the use of certificates. In the period that saw a lot of tension take place because of the cold war, there were fears of the freezing of money held in foreign banks (Mulhearn, 2008). For example, after the famous Hungarian invasion, the Union of Soviet Socialistic Republic feared the deposits that it had made in banks in North America would be frozen as an act of revenge. This is what made it to move all its deposits to the Nardony Bank located it its capital, Moscow. The bank was owned by British charter (McCormick, 2004). The British bank holding the charier would then be depositing the money in the US banks. This way, the union of soviet socialist republic was confident that there was no way its money would be confiscated by its bitter rival, the USA, because the money was in the US in the name of the British chartered bank. In 1957 a lot of money was transferred through the charter and this was the first instance of Eurocurrency transfer. During this time they were being referred to as Euro dollars. As days went by, the deficits in the US made the Euro currency market to expand (McCormick, 2004).
Why Eurocurrency Deposits are Time deposits but not Demand Deposit
Eurocurrency works in forms of futures contact. The Eurocurrency futures contract refers to the fiscal futures contracts that are based on such kind of deposits. Euro currency futures are good ways for international companies to make locks in the interest rates for the money they are planning to borrow or lend some times in the future. Every futures contract has a face value that is notional although the leveraging in them allow for one to be exchanged with a margin of 1000. The use of Eurocurrency trading has been growing widely in the international business and there is a lot of liquidity in the market. The prices in the Eurocurrency are affected by factors such as international policies, inflation, taxes and other indicator prices of the futures are determined by the 3 month market forecast of the lob-or rate of interest that is expected on the date of settlement. The Eurocurrency works in this way If an investor buys a contract at 95.00 and the implied settlement of lib-or is 5, and at the close of the day the price is 95.01, 25 dollars will be paid into the margin account of the investor (McCormick, 2004). If at the close of the day the price is 94.99, 25 will be subtracted form the margin account of the investor. The date of settlement is not always fixed but the price of settlement is determined by many other factors like the lib-or fixing for the particular day and not the fixed contract price of the market (Weiss, 2007).
Eurocurrency futures contract can be taken as a synthetic loan because it is akin to a rate agreement that is pushed forward for borrowing or lending. Buying the contract is akin to lending money and selling it is like to borrowing of funds. For example, if an investor lends one million, at 5 P.A for 3 months at 30-360 bases, the 3 months interest would be 12500 (Weiss, 2007). If on the following day the Eurocurrency futures investor lends that money at 5.01 he will still lose 25 because of variations of interest rates but if on the following day he is able to sell at 4.99 he will gain the same amount he would have lost if he had sold it at 5.01. This way, the Eurocurrency futures contract is similar to a loan. But there are some differences. For a loan the 25 would be earned or lost at the end of the agreed session of the loan and not upfront as with the Eurocurrency contract (Weiss, 2007). This is because a loan has a quality called convexity that the Eurocurrency futures contracts do not have. This is because the rate remains the same regardless of the environment exposed to (Nicola, 1997). This is why the Euro currency is not a good proxy for rates of interests that are expected. This exposes the volatility of the Eurocurrency futures though the difference is adjustable referentially.
Another difference between a loan and a Eurocurrency contract is that in loan, the lender takes that risk that is involved to the person who borrows it but in the Eurocurrency futures, the loans, and principal is never given out meaning that the risk is still in the account balance that is marginal. The clearing house is actually the one that is exposed to most of the risk because of the lower security (Nicola, 1997). The Eurocurrency contracts have 40 quarterly expirations which extend them to a period of ten tears helping to increase the yields expected. Their liquidity decreases as the contract furthers out meaning that they are the most liquid in the market. The CME Eurocurrency futures contract is used to make hedges in the swaps of interest rates meaning that there is an arbitrary relationship between the swap of interest rate market, the rate forward agreement market and the Eurocurrency contract (Nicola, 1997). The Eurocurrency futures can be traded through the implementation of a strategy of spread among the contracts that are multiple to take advantage of the forward curve movements for interest rates pricing in the future. In the banking sector in the US, Eurocurrency is popular for a condition called sweeps. Legally the banks are not supposed to pay interest on the Exchequer accounts of the corporate companies (Nicola, 1997).
However, in their quest to make accommodations for larger businesses, the banks in the USA make automatic transfers that are called sweeps from a corporate account into an investment option , a decision that can be made overnight(Nicola, 1997). This means that a bank can lend a higher deposit proportion if it wants to improve its profit margins by taking advantage of the interest rates. Secondly, the domestic rates are insured and the cost is normally not as risky because it is being borne by the person making the deposits. In the Eurocurrency case, the investors usually call for higher rates due to the high risk involved in the transaction (Nicola, 1997). The most common forms of deposits are made using the dollar of the United States of America because it is the international currency that is used in the international business. In the US such deposits are not subject to federal regulations meaning that they are not controlled by the jurisdictions of the Federal Reserve Bank. They can also sweep them into a mutual fund for the money market or even take them to one of its offshore branches (Nicola, M 1997).
Project Financing and its Unique Features
Project finance is the financing of infrastructure in the long-term. It can also involve industrial projects and is based upon the project cash flows and not the sponsors of the projects and the money they have (Buljevich Park, 1999). It is a very innovative, creative and time saving technique of financing that is normally used by high profile corporate in their numerous projects. Euro Disney land and Euro tunnel are some of the projects that used project financing. It employs a very skilful use of a mix of engineering and financing and some of the toughest projects like refineries, mining and geothermal are funded this way. It is the most common method of financing projects in the world today. Unlike the other methods of financing it utilizes the rationale of fiscal planning, risk assessment and fund raising (Buljevich Park, 1999).
Due to the high level of risk involved, a lot of energy and resources are invested in the planning process, making it the most successful method because few projects financed this way have failed. Some of the planning phase components include contractual design, legislative provisions with the government that is hosting partnerships with the public sector evaluations and financing structures, cash flow projections, accounting and tax considerations and validation of the feasibility of the project (Buljevich Park, 1999).
Project financing is preferred because it maximizes the leveraging of the project and circumvents restrictive covenants that may bind the sponsors to some illogical fiscal obligations. It also allows the lenders to make an appraisal of the project from a stand alone basis that is segregated. It also affords the sponsors a better tax treatment and avoids negative influences of the sponsors credit standing. One of the unique features of the project financing is the involvement of equity financiers that are referred to as sponsors together with syndicated lenders. This means that the risks that the project may be exposed if loans are used alone are minimized through the entry of the equity investors. The loans here are not ordinary loans. They are what are referred to as non recourse loans that are paid from the cash flow and secured by the assets of the project (Buljevich Park, 1999). This is unique because the creditworthiness of the sponsors of the project is not put into consideration neither is the general assets used to guarantee security. The security of the financing is secured by all the assets which include the contracts that produce revenue. This means that the project will be taken over by the lenders if the company does not comply with the terms of the loan (Buljevich Park, 1999).
Another unique feature is the creation of the special purpose entity for every project to cushion the assets of the sponsor from the adverse effects of the failure of the project. This means that the company has no other assets apart from the said project (Buljevich Park, 1999). To ensure that the project is sound fiscally, it is important for the owners of the projects to make capital contribution also. The other factor that makes project financing more complicated and more unique when compared to conventional methods of financing is the shift from the conventional applications like mining and telecoms to public infrastructure covered through the PPP or public private partnerships. The other unique component is the risk identification factor (Besanko Kanatas, 1993). This is because there are political, economic and even technical risks that a project may be subjected to especially in the markets that are emerging or in the countries that are developing. This means that there are risks posed that can make the project not financeable.
This means that special entrants are glowed to cushion the sponsors from the risks and allow the financing to take place (Besanko Kanatas, 1993). The financing is distributed among multiple companies as a way of sharing the risks that are involved. If there are fewer risks, the profits are shared evenly among the multiple parties that are involved in its financing. Another way is the securing of limited resource financing from the sponsors which is more expensive and riskier. After risk allocation there is risk management that mitigates the occurrence of a risk and the consequences it can pose. This is done by the constant reporting to the sponsors on the project account controls (Besanko Kanatas, 1993).
There are also unique risks that are associated with project financing that are not that common in conventional methods of financing. One of the most common risks is the phase of construction risk because of the difficulties of construction and delays that increase the cost of the project. This may put the contract in jeopardy because of the increasing debt and the waning patience of the sponsors. Thus in project financing, the risks must be minimized before the lending takes place by making liquidation claims that will make the sponsors to pay the damage if the project is not completed by the agreed date. This does not happen in conventional financing methods. The sponsors are also required to inject some equity into the project to show their interest in the project (Besanko Kanatas, 1993). This is because if the sponsors are in equity, they will share the risks with the owners of the project. The operation phase risk is minimized by the use of expert reports and making use of supply contracts that are long term to protect against fluctuations in prices.
There are other risks that increase the cost of operation thus making the original projections higher (Besanko Kanatas, 1993). This may have an adverse effect on the owners of the project because the financiers may not cover the inefficiency in the operation. This is why in project financing a reputable operator who is sound financially is given contracts that are secured by performance bonds (Besanko Kanatas, 1993). Project financing can minimize the off take risk by turning the generated product into hard cash. A market risk can occur if the buyer for the product cannot be found and this is mitigated by entering into a sale contract before the lending takes place. The financiers in project finance also do not use technologies that are new and prefer the old ones because of the technical risk that is involved. This is the best way of mitigating technical risks in project finance.
Finally project financing uses non recourse debt that limits the discretion of the management by transferring project revenues to repayment of debts (Besanko Kanatas, 1993). This reduces cash flow making the company to achieve higher leverage as compared to the sponsors. This on the other hand may pose idiosyncratic risks that may vary with the project at hand because of the nature of portfolio financing versus single ventures. This is because both the market and the operating risks are not covered in the recourse while in the traditional financing the host government would cover the market risks. Here, they enjoyed credit protection, overt and covert risk guarantee, derivatives of credit and insurance against macroeconomic risks like the inflation and currency fluctuations (Besanko Kanatas, 1993).
In conclusion, the world is moving away from the conventional corporate finance methods to project finance due to the unique features of project financing that afford both the sponsors of the project and the owner of the project flexibility of the highest level, and also ensures that there is maximum risk reduction even before the financing takes place. The risk posed by using loans only is minimized through the entry of equity investors through equity tools like bonds and rights placement which gives a better cushion from some of the risks because these bonds and rights are usually public, attracting a large number of equity investors that generates sound capital that can see the project through without major expected or unforeseen hiccups.
Eurocurrency deposits usually attract higher rates than in domestic deposits because of several reasons (Mulhearn, 2008). One of the reasons is that the countries never impose a requirement for reserve on the operations of foreign currency. This means that a bank can lend a higher deposit proportion if it wants to improve its profit margins by taking advantage of the interest rates (Weiss, 2007). Secondly, the domestic rates are insured and the cost is normally not as risky because it is being borne by the person making the deposits. In the Eurocurrency case, the investors usually call for higher rates due to the high risk involved in transact. Most common forms of deposits are made using the Dollar of the United States of America because it is the international currency that is used in the international business (McCormick, 2004). In the US such deposits are not subject to Federal regulations meaning that they are not controlled by the jurisdictions of the Federal Reserve Bank. Eurocurrency in Asian banks is referred to as Europe dollar. It is very common for Asian companies to invoice each other using the dollar of the United States of America if the proceeds are held up by domestic banks (Weiss, 2007).
Another form of Eurocurrency is the petrodollars that refer to money earned through the international sale of petroleum and lands into the Eurocurrency accounts (Mulhearn, 2008). For example, Venezuela and Iran have started selling oil in form of Euro just like Saddam Hussein did before the US invaded Iraq some year ago. The use of Eurocurrency by these countries has created what is referred to as petro-market.
Factors That Led to the Development of Eurocurrency
After the Second World War, the amount of the US dollars that were outside their country of origin increased in staggering proportions because of the Marshall Plan (Mulhearn, 2008). The Marshall Plan was a program for the economic reconstruction of West European countries after the war. The money that was given in the initial phase of the plan was transferred to the respective governments of Europe and they were administered commonly by the governments. There were ECA envoys in each capital city in Europe to give advice about the money. The plan money was used to buy goods from the US. The European Nations had already run out of money and their reserves were empty because of the over involvement in the war (Mulhearn, 2008). Their only hope was the marshal plan aid. There was also an establishment of the counterpart funds to inform of the domestic currency of every European state. Because of the state of the European economies at that time, the United States did not have any competition in the international business and the marshal plan increased its influence and that of the dollar (McCormick, 2004). The large amount of the US dollars outside US as a result of the plan was not healthy for international business and after the Korean war, there were fears of fiscal reprisals by the enemies of the united states and this would have affected all the dollars that were lying out of the jurisdiction of the federal reserve bank of the US (Mulhearn, 2008).
A way of safeguarding that money had to be created but this did not come out until Russia faced a similar situation some years later. There were also very many imports taken into the US because the US had grown to become that largest consumer after the war (Mulhearn, 2008). This means that there were enormous amount of its dollars that were being held by banks outside the United Sates of America. Some of these banks were in countries like the Union of Soviet Socialist Republic which had been granted through the use of certificates. In the period that saw a lot of tension take place because of the cold war, there were fears of the freezing of money held in foreign banks (Mulhearn, 2008). For example, after the famous Hungarian invasion, the Union of Soviet Socialistic Republic feared the deposits that it had made in banks in North America would be frozen as an act of revenge. This is what made it to move all its deposits to the Nardony Bank located it its capital, Moscow. The bank was owned by British charter (McCormick, 2004). The British bank holding the charier would then be depositing the money in the US banks. This way, the union of soviet socialist republic was confident that there was no way its money would be confiscated by its bitter rival, the USA, because the money was in the US in the name of the British chartered bank. In 1957 a lot of money was transferred through the charter and this was the first instance of Eurocurrency transfer. During this time they were being referred to as Euro dollars. As days went by, the deficits in the US made the Euro currency market to expand (McCormick, 2004).
Why Eurocurrency Deposits are Time deposits but not Demand Deposit
Eurocurrency works in forms of futures contact. The Eurocurrency futures contract refers to the fiscal futures contracts that are based on such kind of deposits. Euro currency futures are good ways for international companies to make locks in the interest rates for the money they are planning to borrow or lend some times in the future. Every futures contract has a face value that is notional although the leveraging in them allow for one to be exchanged with a margin of 1000. The use of Eurocurrency trading has been growing widely in the international business and there is a lot of liquidity in the market. The prices in the Eurocurrency are affected by factors such as international policies, inflation, taxes and other indicator prices of the futures are determined by the 3 month market forecast of the lob-or rate of interest that is expected on the date of settlement. The Eurocurrency works in this way If an investor buys a contract at 95.00 and the implied settlement of lib-or is 5, and at the close of the day the price is 95.01, 25 dollars will be paid into the margin account of the investor (McCormick, 2004). If at the close of the day the price is 94.99, 25 will be subtracted form the margin account of the investor. The date of settlement is not always fixed but the price of settlement is determined by many other factors like the lib-or fixing for the particular day and not the fixed contract price of the market (Weiss, 2007).
Eurocurrency futures contract can be taken as a synthetic loan because it is akin to a rate agreement that is pushed forward for borrowing or lending. Buying the contract is akin to lending money and selling it is like to borrowing of funds. For example, if an investor lends one million, at 5 P.A for 3 months at 30-360 bases, the 3 months interest would be 12500 (Weiss, 2007). If on the following day the Eurocurrency futures investor lends that money at 5.01 he will still lose 25 because of variations of interest rates but if on the following day he is able to sell at 4.99 he will gain the same amount he would have lost if he had sold it at 5.01. This way, the Eurocurrency futures contract is similar to a loan. But there are some differences. For a loan the 25 would be earned or lost at the end of the agreed session of the loan and not upfront as with the Eurocurrency contract (Weiss, 2007). This is because a loan has a quality called convexity that the Eurocurrency futures contracts do not have. This is because the rate remains the same regardless of the environment exposed to (Nicola, 1997). This is why the Euro currency is not a good proxy for rates of interests that are expected. This exposes the volatility of the Eurocurrency futures though the difference is adjustable referentially.
Another difference between a loan and a Eurocurrency contract is that in loan, the lender takes that risk that is involved to the person who borrows it but in the Eurocurrency futures, the loans, and principal is never given out meaning that the risk is still in the account balance that is marginal. The clearing house is actually the one that is exposed to most of the risk because of the lower security (Nicola, 1997). The Eurocurrency contracts have 40 quarterly expirations which extend them to a period of ten tears helping to increase the yields expected. Their liquidity decreases as the contract furthers out meaning that they are the most liquid in the market. The CME Eurocurrency futures contract is used to make hedges in the swaps of interest rates meaning that there is an arbitrary relationship between the swap of interest rate market, the rate forward agreement market and the Eurocurrency contract (Nicola, 1997). The Eurocurrency futures can be traded through the implementation of a strategy of spread among the contracts that are multiple to take advantage of the forward curve movements for interest rates pricing in the future. In the banking sector in the US, Eurocurrency is popular for a condition called sweeps. Legally the banks are not supposed to pay interest on the Exchequer accounts of the corporate companies (Nicola, 1997).
However, in their quest to make accommodations for larger businesses, the banks in the USA make automatic transfers that are called sweeps from a corporate account into an investment option , a decision that can be made overnight(Nicola, 1997). This means that a bank can lend a higher deposit proportion if it wants to improve its profit margins by taking advantage of the interest rates. Secondly, the domestic rates are insured and the cost is normally not as risky because it is being borne by the person making the deposits. In the Eurocurrency case, the investors usually call for higher rates due to the high risk involved in the transaction (Nicola, 1997). The most common forms of deposits are made using the dollar of the United States of America because it is the international currency that is used in the international business. In the US such deposits are not subject to federal regulations meaning that they are not controlled by the jurisdictions of the Federal Reserve Bank. They can also sweep them into a mutual fund for the money market or even take them to one of its offshore branches (Nicola, M 1997).
Project Financing and its Unique Features
Project finance is the financing of infrastructure in the long-term. It can also involve industrial projects and is based upon the project cash flows and not the sponsors of the projects and the money they have (Buljevich Park, 1999). It is a very innovative, creative and time saving technique of financing that is normally used by high profile corporate in their numerous projects. Euro Disney land and Euro tunnel are some of the projects that used project financing. It employs a very skilful use of a mix of engineering and financing and some of the toughest projects like refineries, mining and geothermal are funded this way. It is the most common method of financing projects in the world today. Unlike the other methods of financing it utilizes the rationale of fiscal planning, risk assessment and fund raising (Buljevich Park, 1999).
Due to the high level of risk involved, a lot of energy and resources are invested in the planning process, making it the most successful method because few projects financed this way have failed. Some of the planning phase components include contractual design, legislative provisions with the government that is hosting partnerships with the public sector evaluations and financing structures, cash flow projections, accounting and tax considerations and validation of the feasibility of the project (Buljevich Park, 1999).
Project financing is preferred because it maximizes the leveraging of the project and circumvents restrictive covenants that may bind the sponsors to some illogical fiscal obligations. It also allows the lenders to make an appraisal of the project from a stand alone basis that is segregated. It also affords the sponsors a better tax treatment and avoids negative influences of the sponsors credit standing. One of the unique features of the project financing is the involvement of equity financiers that are referred to as sponsors together with syndicated lenders. This means that the risks that the project may be exposed if loans are used alone are minimized through the entry of the equity investors. The loans here are not ordinary loans. They are what are referred to as non recourse loans that are paid from the cash flow and secured by the assets of the project (Buljevich Park, 1999). This is unique because the creditworthiness of the sponsors of the project is not put into consideration neither is the general assets used to guarantee security. The security of the financing is secured by all the assets which include the contracts that produce revenue. This means that the project will be taken over by the lenders if the company does not comply with the terms of the loan (Buljevich Park, 1999).
Another unique feature is the creation of the special purpose entity for every project to cushion the assets of the sponsor from the adverse effects of the failure of the project. This means that the company has no other assets apart from the said project (Buljevich Park, 1999). To ensure that the project is sound fiscally, it is important for the owners of the projects to make capital contribution also. The other factor that makes project financing more complicated and more unique when compared to conventional methods of financing is the shift from the conventional applications like mining and telecoms to public infrastructure covered through the PPP or public private partnerships. The other unique component is the risk identification factor (Besanko Kanatas, 1993). This is because there are political, economic and even technical risks that a project may be subjected to especially in the markets that are emerging or in the countries that are developing. This means that there are risks posed that can make the project not financeable.
This means that special entrants are glowed to cushion the sponsors from the risks and allow the financing to take place (Besanko Kanatas, 1993). The financing is distributed among multiple companies as a way of sharing the risks that are involved. If there are fewer risks, the profits are shared evenly among the multiple parties that are involved in its financing. Another way is the securing of limited resource financing from the sponsors which is more expensive and riskier. After risk allocation there is risk management that mitigates the occurrence of a risk and the consequences it can pose. This is done by the constant reporting to the sponsors on the project account controls (Besanko Kanatas, 1993).
There are also unique risks that are associated with project financing that are not that common in conventional methods of financing. One of the most common risks is the phase of construction risk because of the difficulties of construction and delays that increase the cost of the project. This may put the contract in jeopardy because of the increasing debt and the waning patience of the sponsors. Thus in project financing, the risks must be minimized before the lending takes place by making liquidation claims that will make the sponsors to pay the damage if the project is not completed by the agreed date. This does not happen in conventional financing methods. The sponsors are also required to inject some equity into the project to show their interest in the project (Besanko Kanatas, 1993). This is because if the sponsors are in equity, they will share the risks with the owners of the project. The operation phase risk is minimized by the use of expert reports and making use of supply contracts that are long term to protect against fluctuations in prices.
There are other risks that increase the cost of operation thus making the original projections higher (Besanko Kanatas, 1993). This may have an adverse effect on the owners of the project because the financiers may not cover the inefficiency in the operation. This is why in project financing a reputable operator who is sound financially is given contracts that are secured by performance bonds (Besanko Kanatas, 1993). Project financing can minimize the off take risk by turning the generated product into hard cash. A market risk can occur if the buyer for the product cannot be found and this is mitigated by entering into a sale contract before the lending takes place. The financiers in project finance also do not use technologies that are new and prefer the old ones because of the technical risk that is involved. This is the best way of mitigating technical risks in project finance.
Finally project financing uses non recourse debt that limits the discretion of the management by transferring project revenues to repayment of debts (Besanko Kanatas, 1993). This reduces cash flow making the company to achieve higher leverage as compared to the sponsors. This on the other hand may pose idiosyncratic risks that may vary with the project at hand because of the nature of portfolio financing versus single ventures. This is because both the market and the operating risks are not covered in the recourse while in the traditional financing the host government would cover the market risks. Here, they enjoyed credit protection, overt and covert risk guarantee, derivatives of credit and insurance against macroeconomic risks like the inflation and currency fluctuations (Besanko Kanatas, 1993).
In conclusion, the world is moving away from the conventional corporate finance methods to project finance due to the unique features of project financing that afford both the sponsors of the project and the owner of the project flexibility of the highest level, and also ensures that there is maximum risk reduction even before the financing takes place. The risk posed by using loans only is minimized through the entry of equity investors through equity tools like bonds and rights placement which gives a better cushion from some of the risks because these bonds and rights are usually public, attracting a large number of equity investors that generates sound capital that can see the project through without major expected or unforeseen hiccups.
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