Question

Describe how forwards, futures, options, and swaps can be used to hedge your foreign risk.

Answer 1

1.

Forwards and futures

These derivatives are used to fix a specific price and a specific date today.

So, if you want to hedge a currency risk, then these derivatives can be used to fix the exchange rate today.

These exchange rates are known as forward rates.

Entering to forward and future contracts to exchange certain amount of foreign curency can help you reduce your foreign risk, specifically exchange rate risk.

2.

Options

These are option to buy (call) or option to sell (put) derivatives.

These derivatives can be used to buy an option to buy specific product at a specific price.

These are contingency claim and not forward commitment.

You will exercise the option only if you want to (based on a condition, when the options will be in the money)

Now say for example, you import crude oil, if you want option to buy crude oil at a specific price then these derivatives can be used. Using options you can hedge the risk of movement in price of crude oil.

3.

Swaps

These are series of netted payments.

One party agrees to pay fixed and the other agrees to pay floating, this is simple swap (plain vanilla)

Swap can be used to hedge foreign risk.

If one has taken debt in foreign currency and wants to hedge the exposure of foreign currency then swaps can be used. This party can enter into a contract to swap his currency with the foreign currency.

All the above derivatives can be used to hedge the risk. Both the parties (long and short) are hedging their own risks.