Hedging Essay Example | Topics and Well Written Essays - 750 words

Hedging - Essay Example There are various ways in hedge oneself from exchange rate risk by the use of financial derivative products, and a combination of strategies using these products. The three top runners for hedging purposes in exchange rates are Forward Contracts, Futures Contracts and Options. We’ll discuss the strategies which can be formed in each case, and then conclude which strategy would be most suitable for our current scenario. A forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. The most advantageous feature of a forward contract is that it costs nothing to enter into such an agreement. The difference between the spot and the forward price is the forward premium or forward discount, depending on the swap points of the currency pair involved. Forward contracts are traded over the counter, and are more customized for individual customers. Another feature of a forward contract is that there is no specific margin call mechanism. Since there is no cost of entering into this agreement, margin calls are non-existent in this type of trade. Moreover, it is not regulated by an exchange or clearing house, thus it does not involve the hassles which occur in such cases. However, a forward contract obligates the customer to deliver or take delivery of the underlying asset at the time of maturity. Failure to do so would result in a breach of contractual obligations and can lead to litigation. But we have to keep in mind that there is no guarantee that a customer will honor the contract. In our case, the Virtual Books can enter in to a forward contract to fix a forward price for its imports as well as repatriated profits. In the case of its import, if the forward price is less than the prevalent spot rate on the day of taking up that contract, he will be losing money on the contract. If the spot rate is lower than the agreed forward rate, then it will be gaining on t he contract. In case it’s relatively the same, Virtual Books will no gain nor lose. The reverse case applies for its repatriated profits in which he is selling Euros and receiving GBP. The next alternative in line is Futures Contracts. A futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today known as the futures price. A futures contract operates in ways similar to a forward contract; however, there are a few differences which make the two distinguishable. First of all, a futures contract is traded on an exchange. They are highly standardized and are backed by a clearing house. Unlike forwards, an initial margin must be put up with the clearing house as a form of collateral. Fluctuations in the price of the underlying asset will reduce or increase the outstanding initial margin of the buyer/seller. Once a minimum threshold has been hit, margin call s are made so as to deposit funds to meet the minimum margin levels. Futures are backed by the clearing house, so in case any party defaults, the other party will still be able to deliver/take delivery of the underlying asset. In the case of Virtual Books, if they enter into a futures agreement, they will go long in Euro Futures which will obligate them to buy EUR against the GBP. In the case of their repatriated profit