Question

"Explain the difference between a forward and futures contract." When would each be used in foreign currency hedging?

Answer 1

Difference between a forward and futures contract

1. Trading - Forward contract are traded on personal basis or on telephone or otherwise. Futures contracts are traded in a competitive arena.
2. Size of contract - Forward contract are made as per requirements and they have no standardized size. Futures contracts are standardized in terms of quantity or amount as the case may be.
3. Organized exchanges - Forward contracts are traded in an over the counter market. Futures contracts are standardized in terms of quantity or amount or as the case maybe.
4. Settlement - The settlement in forward contract takes place on date agreed upon between the parties. Futures contracts settlements are made daily via exchange's clearing house.
5. Transaction costs - Cost of forward contracts are based on bid-ask spread. Futures contracts involve brokerage fees for buy and sell orders.
6. Margins - Margins are not required in forward contract. In futures contract every participant is subject to maintain margin as decided by the exchange authorities.
7. Credit Risk - In forward contracts credit risk is borne by each part and, therefore, every party has to bother for the creditworthiness of the counter-party. In futures contracts the transaction is a two way transaction, hence the parties need not bother about the creditworthiness of each party.

Foreign currency hedging using Forward Contract

Transaction exposure arises when a firm has known amount of foreign currency payable or receivable - the home currency equivalent of which is unknown. Hedging may be defined as an activity of converting uncertainty into certainty. The simplest hedge in the world is Forward Cover.

• When Foreign Currency is payable - Buy Foreign Currency forward
• When Foreign Currency is receivable - Sell Foreign Currency forward

A Forward contract obliges one party to buy and other to sell a specified quantity of a nominated financial instrument at a predetermined price on a specified date in future.

Foreign currency hedging using Futures Contract

Futures Contract is very similar to forward contract. All the transactions are carried out through exchange clearing system thus avoiding other party risk. In a futures contract the price at which the currency can be brought or sold is determined at an earlier stage for the transaction to be taken in future. This is generally entered to avoid exchange rate volatility.

For example - Suppose there is an U.S exporter who has exported goods to India and since he will receive money for such export he will be afraid of $ value falling. Therefore he would enter into such a futures contract that even if $ value falls he would gain money from the Futures contract and this would act as a hedge.