Futures Hedging
A futures contract compels the buyer to purchase a particular quantity of assets within a certain period of time. The price of the purchase is agreed in the contract at the time of entering this contract. The asset that is to be purchased is referred to as the underlying asset and the time when this asset is purchased or sold is known as the expiry date or maturity date. While the major difference between a futures contract from an options contract is the obligation to purchase an asset, forward contracts also oblige the buyer to purchase the underlying asset. However, in contrast to forward contracts, futures contracts are drawn according to standardized forms and are more liquid since they are traded on secondary markets. Futures contracts provide more liquidity in comparison with forward contracts. A party that enters a futures agreement to purchase security may sell this right at the available market price.
Hedging with futures implies lowering the risk of price growth of the underlying asset for the buyer. Another advantage is the fact that the establishment of a predetermined price assists in management decisions. In the meanwhile, the disadvantages of futures contract include the fact that gains that may be obtained from price decrease are limited. Furthermore, futures position requires a margin deposit. The contract quantity is normally standardised and maybe not in line with cash quantity. Hedging a portfolio with futures implies that an investor who has a long position in the portfolio can enter a futures contract to minimise the downside risk as the investor would still be able to sell the portfolio at the predetermined price. However as the investor is protected against a decrease in prices, he or she may not be able to enjoy the abnormal benefits from growth in price of the underlying asset above the futures price. This incorporates the basis risk of futures hedging. In addition to this, the investor has a risk of a margin call when his or her position might be forced to be closed if the margin account does not have a sufficient balance.
Forwards Hedging
Forward contracts are similar to futures as they imply an obligation of a buyer to purchase particular security at a particular date. The obligation clause is the major difference from the options contracts. However, there are differences from futures contracts as well. Forward contracts are rather unique and are not as standardised as futures. The prices at which the agreements are settled are different. The settlement price of futures is the price that is fixed on the last trading date. In the meanwhile forwards prices are agreed on the trade date at the start. Forward contracts involve no cash flows until the delivery period. In contrast, futures contracts include margin requirements and margin calls. Forward hedging implies forward selling the securities or currency. For example, multinational corporations may sell the currency that is received as earnings by their subsidiaries. In this way, corporations are able to create cash outflows to hedge translation exposure. Still, hedging translation exposure may be inappropriate due to inaccurate earnings forecasts. In some cases, translation losses may be significantly higher than the benefits obtained from forward hedging.
One of the major disadvantages of forward contracts is the credit risk or default risk that is inherent to forward hedging strategy. One of the parties of the contract may fail to fulfil its obligations under the contract. Then, although the forward price of a security is a prediction of a spot price, some unexpected events may happen and one of the parties of the forward contract may face undesired price movements. The actual spot price at the moment of delivery of an asset or security may be different from the forward price that has been agreed on in the forward contract. However, there are particular advantages of forward contracts as well. For example with respect to foreign exchange markets forward exchange rates are negotiable. This is especially important for large companies that can make use of their market power in negotiations with a bank to obtain a favourable forward market rate. Then, the banking system is available 24 hours a day, while futures markets are not open overnight. This makes forward contracts more attractive to some parties.
Swap Hedging
Swap deals involve an exchange of securities and act as techniques for the management of risks. Companies obtain various assets to generate income and bear particular liabilities for financing such acquisition of assets. In some cases, firms maybe not satisfied with the assets that are obtained or the liabilities that are incurred. For example, a company may wish to shift from a fixed interest rate loan to a floating interest rate loan in order to avoid the interest rate risk. Such a company may enter an interest rate swap to realise its objective. Another type of swaps is a currency swap. If a company predicts a decrease in the value of a particular currency it may exchange the existing asset that yields income in this currency for another asset that generates income in a currency that is expected to be stronger. Consequently, interest rate swaps and currency swaps are financial strategies that involve the exchange of liabilities or assets. Interest rate swaps are popular among companies that have comparative advantages in particular markets. A company may have a comparative advantage in a floating rate market and therefore borrow funds there. However, it may be actually more interested in a fixed-rate loan. In this case, the company may enter a swap agreement to exchange the fixed-rate loan for a floating rate loan. The same action may be observed if a company has a comparative advantage in a fixed rate market but is interested in a floating rate loan.
One of the disadvantages of swap deals is the fact that companies may default on interest payments in case of interest rate swaps. The default risk is similar to the one that is observed in forward hedging. In addition to this, swap deals do not provide high level of liquidity. Swap hedging involves particular risks. They include interest rate risk, the cost of lost opportunity, credit risk, basis risk, and legislative risk. As with any derivatives that are used in hedging strategies, swap contracts may generate losses if markets change significantly and the derivatives are used as a speculative instrument. However, the application of the derivatives including swaps implies that financial risks are at least partially transferred to other parties. These parties may be more skilful at managing these risks. With the help of swap deals, interest rate risk may be hedged.