Hedging Transaction Exposure – Forward, Futures & Options
"Hedging" means taking an opposite position to reduce risk. It is like buying insurance for your money.
1. Hedging Instruments
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3. Currency Options (The Flexible Friend)
- Concept: Right to buy/sell, but not the obligation.
- Call Option: Right to Buy $. (Use if you are an Importer fearing appreciation).
- Put Option: Right to Sell $. (Use if you are an Exporter fearing depreciation).
- Cost: You pay a "Premium" upfront. If rate moves in your favor, you let the option expire and enjoy the market rate.
2. Which Tool to Use?
| Scenario | Best Tool | Why? |
|---|---|---|
| Exact date/amount known | Forward Contract | Perfect hedge. 100% certainty. |
| Uncertain date (Tender) | Option | If you don't win the tender, walk away. |
| Small amount / Trading | Futures | Low transaction cost, high liquidity. |
3. Money Market Hedge
If derivatives are expensive, use the Money Market.
- Scenario: Need to pay $1000 in 3 months.
- Action: Buy $1000 today at Spot Rate. Invest it in a US Bank Deposit for 3 months.
- Result: You have eliminated the future rate risk by paying today.
4. Exam Notes: Writing the Answer
Question: "Distinguish between Forward and Future Contracts." (5 Marks)
Answering Strategy:
- Market: OTC (Forward) vs Exchange (Future).
- Size: Custom (Forward) vs Standard (Future).
- Liquidity: Low (Forward) vs High (Future).
- Note: Options provide "Downside protection with Upside potential".
Summary
- Forward: Bound to act. Good for committed deals.
- Option: Freedom to act. Good for uncertain deals.
- Money Market: Do-it-yourself hedge.
Quiz Time! 🎯
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