Hedging Strategies: Forwards, Futures & Options - Essay Example

Virtual Books has exposure to potential exchange rate risk. There are various ways to 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 exchange or clearinghouse, 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, Virtual Books can enter into 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 prevailing 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 the contract. In case it’s relatively the same, Virtual Books will not 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 that make the two distinguishable. First of all, a futures contract is traded on an exchange. They are highly standardized and are backed by a clearinghouse. Unlike forwards, an initial margin must be put up with the clearinghouse 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 calls are made so as to deposit funds to meet the minimum margin levels. Futures are backed by the clearinghouse, so in case of 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 profits, they can go long in the GBP futures so they can buy GBP at a specified rate.

The last alternative is that of Options. An Option is a contract that gives the buyer the right but not the obligation to buy/sell a specified quantity and quality of a certain asset within a specified period or on a specific date at an agreed price when entering the contract. For this option, however, the buyer must pay a premium to the seller. Options are both exchange-traded and OTC. Furthermore, options have a lot of versatility like European options or American options. In our particular case, Virtual Books can enter into a long call option so that it has the right but not obligation to buy EUR from the banking institution for its import. Similarly, it can enter into a long put to sell its repatriated profits in EUR for equivalent GBP at the determined rate.

After looking at all three alternatives, I would advise Virtual Books to opt for the Forward Contract alternative. There are several reasons for this which are:
1. No upfront cost: In the future, you must pay a margin, and in options, you must pay a premium.
2. Fluctuating price: The exchange rate graph depicts strong volatility in the currency pair’s movements and hence looking at a forward price seems logical.
3. Customized features: Forward contracts are customized for the company and hence more beneficial.
4. No margin calls: No margin call mechanisms apply in forwarding contracts.
Hence Forward Contracts are the recommendation I would make for Virtual Books Ltd. Read More