The company’s decision to use FX derivatives to manage the FX risks means that the company already entered into a transaction, or is likely to have a commitment in a foreign currency. Depends on the terms of the transaction the use of some FX derivatives will be more appropriate than the others. For example, if the UK-based company trades on credit, the agreed amount in USD that it supposed to receive is subject to uncertainty in home currency terms. In this case, the company can hedge FX risk exposure by entering into a short USD/long GBP position in forward or futures contracts. The main advantage of this hedging is that it reduces FX risks and provides certainty on the receipt of the future net income. In particular, hedging can add value if net income received in USD represents a greater proportion of total company’s revenue (Muff et al, 2008). Conversely, if the company expected to meet its future liabilities in the US currency to pay out to its suppliers, or finance investment project with high growth opportunities, a long USD/short GBP position in forward or futures contracts can help in budgeting the costs.
FX forward and futures contracts are trade agreements that enable two parties to lock in the price at the time of the transaction to exchange one currency for another at a specified future time. The agreement is a binding commitment for both counterparties, the terms of which, such as the amount of the transaction, the payment procedure, the settlement date, and the FX rate, are predetermined in advance (Giddy, no date). The initial market value of the contract is usually zero, however, any changes in the market condition will increase the value of the contract of one counterparty while decrease by the same amount the value of the contract of another. Although forward and futures contracts are similar in many ways, the main difference is that forward contracts are tailor-made over-the-counter (OTC) transactions while futures are standardized contracts traded on a regulated exchange. Forward contracts are the most frequently employed method of hedging transactions in foreign currencies. Under the terms of the forward agreement, the gain or loss is usually realized at the end of the agreement. Unlike future contracts, there are no specific requirements to maintain a margin account, which makes it easier for the company to hold the position throughout the life of the agreement despite FX rate fluctuations. Although most of the FX forward contracts lead to a cash settlement at the end of the agreement, the main disadvantage is that both counterparties to the agreement exposed to credit risk. For example, if hedge proved to be valuable for one of the counterparties, another counterparty may be unable to meet its commitment and default, sometimes at great cost to the first party. The …show more content…
The exchange requires the hedger who holds the position in a future contract to maintain a margin account, which entails an additional cost. However, the main disadvantage of futures is the difficulty of matching the exact amount and the maturity date to hedge the underlying currency exposure, which allows future contracts to be tradable and be closed prior to the maturity date. There are a number of factors that can cause forward and futures prices to be different; although in the FX market the difference is statistically and economically insignificant (Cornell and Reinganum, 1981). Despite different features, both forward and futures contracts serve the same
FX forward and futures contracts are trade agreements that enable two parties to lock in the price at the time of the transaction to exchange one currency for another at a specified future time. The agreement is a binding commitment for both counterparties, the terms of which, such as the amount of the transaction, the payment procedure, the settlement date, and the FX rate, are predetermined in advance (Giddy, no date). The initial market value of the contract is usually zero, however, any changes in the market condition will increase the value of the contract of one counterparty while decrease by the same amount the value of the contract of another. Although forward and futures contracts are similar in many ways, the main difference is that forward contracts are tailor-made over-the-counter (OTC) transactions while futures are standardized contracts traded on a regulated exchange. Forward contracts are the most frequently employed method of hedging transactions in foreign currencies. Under the terms of the forward agreement, the gain or loss is usually realized at the end of the agreement. Unlike future contracts, there are no specific requirements to maintain a margin account, which makes it easier for the company to hold the position throughout the life of the agreement despite FX rate fluctuations. Although most of the FX forward contracts lead to a cash settlement at the end of the agreement, the main disadvantage is that both counterparties to the agreement exposed to credit risk. For example, if hedge proved to be valuable for one of the counterparties, another counterparty may be unable to meet its commitment and default, sometimes at great cost to the first party. The …show more content…
The exchange requires the hedger who holds the position in a future contract to maintain a margin account, which entails an additional cost. However, the main disadvantage of futures is the difficulty of matching the exact amount and the maturity date to hedge the underlying currency exposure, which allows future contracts to be tradable and be closed prior to the maturity date. There are a number of factors that can cause forward and futures prices to be different; although in the FX market the difference is statistically and economically insignificant (Cornell and Reinganum, 1981). Despite different features, both forward and futures contracts serve the same