Hedging is a risk management strategy used in limiting or eliminating chances of loss from uncontrollable changes in the prices of commodities, currencies, or securities. A hedge is an investment position that used to reduce potential losses that may be occur in an investment for an individual or an organisation. In short, hedging is a transfer of risk without buying insurance policies. Hedge funds are designed to reduce an investment risk while maintaining a good return on investment.
Hedging refers to managing risk to an extent that makes it bearable. In international trade and dealings foreign exchange play an important role. Fluctuations in the foreign exchange rate can have ...view middle of the document...
5 dollar per pound. However, since the exchange rate could fluctuate and end with a possible depreciation of US dollar, Wates enters into a forward agreement with Bank of America to fix the exchange rate at 1.5 dollar per pound. The forward contract is a legal agreement, and therefore constitutes an obligation on both sides. The First State Bank may have to find a counter party for this transaction – either a party who wants to hedge against the appreciation of 1,500,000 dollars expiring at the same time or a party that wishes to speculate on an upward trend in dollars. If the bank itself plays the counter party, then the risk would be borne by the bank itself. The existence of speculators may be necessary to play the counter party position. By entering into a forward contract Wates is guaranteed of an exchange rate of 1.5 dollar per pound in the future irrespective of what happens to the spot dollar exchange rate. If Dollar were to actually depreciate, Wates would be protected. However, if it were to appreciate, then Wates would have to forego this favourable movement and hence bear some implied losses. Even though this favourable movement is still a potential loss, Wates proceeds with the hedging since it knows an exchange rate of 1.5 dollar per pound is consistent with a profitable venture.
Pros | Cons |
Can be tailored to the specific requirements of a customer | Not marketable as it is negotiated between two parties only |
Has also no payable front-end fee as nothing is payable or receivable until settlement date | Binding agreements that must be settled at the settlement date as it is an obligation |
Required no borrowing or lending of capital | Do not allow either party (buyer or seller) to take advantage the favourable moment of the price anymore |
It is an over-the-counter (OTC) instrument | More expensive than comparable futures contracts |
Private deals between two individuals | Lack of liquidity |
Lower information and transaction cost | Difficulty to find a counter party |
| Subject to default risk |
| OTC are generally not opaque |
Importance and benefits of Hedging
How Does a Forward Contract for Commodities Work?
There are many advantages of hedging with forward contract. Unlike futures, forward contract can be tailored to the specific requirements of a customer. They can be as flexible as the parties involved want them to be. It has also no payable front-end fee as nothing is payable or receivable until settlement date. Besides that, it required no borrowing or lending of capital. Forward contracts do not trade on a centralised exchange and are therefore regarded as over-the-counter (OTC) instruments. ...