Question

What are the advantages and disadvantages of forwards, futures, options and swaps in managing FX risk.

Answer 1

Forward Contracts

S no.	Advantage	S no.	Disadvantage
1	Since these contracts are over the counter(Traded/ created by dealers in a market with no central location) agreement so they are custom intruments(they have unique terms for size , expiration date, asset type and quality.	1	Being over the counter contract these contracts are subject to counterparty risk i.e default risk when the counterparty does not honor their commitment.
2	Neither party to contract makes payment at intiation of the forward contract.	2	These contracts are not exchange traded and not backed by clearing house guarantee.
3	Very easy to understand	3	There is no mark to market through daily settlement of gains and losses.
		4	These contracts are not regulated and do not trade in organized market
		5	Since these contracts are not exchange traded so it is difficult to find the conuterparty and also there is illiquid market

Future Contracts:

S no.	Advantage	S no.	Disadvantage
1	Exchange traded contracts backed by clearing house guarntee so no counter party risk	1	Since these contracts are exchange traded there are standardized contract terms for listed future contracts i.e quality and quantity of asset required and delivery procedures.
2	These contracts mark to market through daily cash settlement of gains and losses.	2	Here both long and short parties are required to deposit margin money as a performance guarantee prior to enter into future contract.
3	These contracts are Government regulated and trade in organized market
4	Since these contracts are exchange traded so it is easy to find the conuterparty and also there is liquid market

Swaps
S no.	Advantage	S no.	Disadvantage
1	Since these contracts are over the counter(Traded/ created by dealers in a market with no central location) agreement so they are custom intruments(they have unique terms for size , expiration date, asset type and quality.	1	Being over the counter contract these contracts are subject to counterparty risk i.e default risk when the counterparty does not honor their commitment.
2	Neither party to contract makes payment at intiation of the Swapcontract.	2	These contracts are not exchange traded and not backed by clearing house guarantee.
3	Long term contracts than future or options	3	Most participants are large institutions and individuals are rarely swaps market participants
		4	These contracts are not regulated and do not trade in organized market
		5	Since these contracts are not exchange traded so it is difficult to find the conuterparty and also there is illiquid market
		6	Early termination of contract leads to breakerage cost.
Options
S no.	Advantage	S no.	Disadvantage
1	Since option is a right to owner of contract to buy or sell an underlying asset at given exercise price so its an advantage for buyer to exercise or not the option.Risk is just for premium amount to buy the option	1	Since option is a right to owner of contract to buy or sell an underlying asset at given exercise price so its an disdvantage for seller as he is obligated to perform if buyer exercise the option
2	They can be OTC or Exchange traded contracts	2	Unlimited loss for seller( of call option)
3	High Returns in comparision to risk	3	Quickly become worthless
4	Cheap to trade

Source:	CFA level 1 ,Year 2015,Schweser notes on derivatives.
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