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
1. Forward Contract (Custom)
- Agreement to buy/sell at fixed future rate.
- OTC: Traded between Bank and Client.
- Customizable: Any amount ($123.55), Any date.
- Risk: Counterparty default risk.
VS
2. Currency Future (Standard)
- Standard contract traded on Stock Exchange (NSE).
- Fixed Size: $1000 per lot.
- Fixed Date: Expiry on last Friday of month.
- Risk: Zero (Exchange guarantee).
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! 🎯
Test Your Knowledge
Question 1 of 5
1. Which contract gives the Right but NOT the Obligation to buy/sell?