Hedging Strategies - Essay Example

Hedging Strategies: Forwards, Futures & Options Munaf Usmani Academia Research Virtual Books has two streams of cash flows which are exposed to potential exchange rate risk. The first cash flow comprises of the profits which are being repatriated from Slovakia. Now the case specifies that the money is received in Pound Sterling, however Slovakia has adopted the Euro as its currency and we shall assume that it remits Euros which are converted into pounds and then given to Virtual Books. The second stream of cash flows is the import payments which Virtual Books must make to its sister concern in Slovakia.

These payments must be made in Euros and hence, Virtual Books is exposed to potential exchange rate risk on these transactions. In order to mitigate and hedge this exchange rate risk, Virtual Books has various alternatives to eliminate this risk. The first alternative is that of Forward Contracts. A forward contract is an agreement between two parties to buy/sell a specified asset at a forward price at a specified date. Forward Contracts are just a commitment to deliver/take delivery of the said asset and at the time of agreement, there is no exchange.

Hence the cost of entering into a forward contract is nothing. Other advantages of a forward contract include customization for the customer, and OTC trade. The major drawback is that this contract is an obligation which must be honored. In case it is not honored, the customer can go for or be taken to litigation. In the case of Virtual books, it can enter into a forward agreement with its bank to buy euros at a predetermined forward price. By doing so, they can eliminate the potential risk involved in taking a price on the day of the payment.

There will obviously be an opportunity cost involved. Assuming that the market is above the forward price on the day of taking up the contract, the customer will be losing out on a potential gain. In case it is lower than the forward price, Virtual Books will be in the money on this contract. The opposite applies for the profits its receiving. The next alternative is Futures Contracts. Futures are an agreement between two parties to parties to buy/sell a specified asset at a predetermined price, called the future price, at a specified date.

Although forwards and futures seem to be very similar in nature, there is in fact several differences between the two. First of all, it is traded over an exchange. It is highly standardized and can only be traded in specific tenors. Furthermore, you must put up an initial margin with the clearing house. As Christos (2007) discusses in his article “Futures Contract”, daily mark to markets on that position will cause the balance to increase or decrease and can also trigger margin calls. Thus entering into a futures agreement requires initial capital.

However, the biggest advantage in this mechanism is that in case the other party defaults, the customer/bank is still going to deliver/take delivery of the underlying asset. In the case of Virtual Books, it can go long in Euro 3-month futures so that it can lock in a price today for its imports. Alternatively, it can go short in Euro futures for selling its Euro profits to obtain GBP. However, the issue with this is that since the tenors being traded do not change, the profits should only be repatriated on the exact time of maturity of the future contracts.

The last alternative available to Virtual Books is via the use of Option Derivatives. Unlike the conventional forwards and futures, options are contracts that give 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.

For Virtual Books, its can devise its strategy whereby it will long a call option. This will give it the right but not the obligation to buy Euros at the strike price if the market is unfavorable. If the market price is more favorable than the strike price of the call, then they will simply not utilize the option. In that case, the premium is a loss for them. Similarly, it can enter into a long put to sell its repatriated profits in EUR for equivalent GBP at the determined rate. After going through these alternatives, I suggest booking Forward Contracts.

There are various reasons for this including the following: 1. No margin calls: No margin call mechanisms apply in forward contracts. 2. Fluctuating price: The exchange rate graph depicts a strong volatility in the currency pair’s movements and hence looking in a forward price seems logical. 3. No upfront cost: In futures, you must pay a margin, and in options, you must pay a premium. 4. No margin calls: No margin call mechanisms apply in forward contracts. Reference List: Christos Dimoulas, Riccardo Pucella, Matthias Felleisen. 2007. “Futures Contracts”. Online. 2007.

http://www.ccs.neu.edu. March 03, 2011. Hull, J. C., 2007. Options, Futures and Other Derivatives. 6 ed. USA, Prentice Hall/ Financial Times.