Question

1. How would you use a forward contract, futures contract, and a call option contract on the US $ / Australian $ FX rate to hedge the FX risk of paying a $A1 million bill in Australian Dollars for a purchase to be delivered and paid in 90 days? What are the pro and cons of using each FX derivative in general?     

Answer 1

The payment is to be made is Australian dollars after 90 days.

Due to this any adverse fluctuations in the exchange rate can increase the liability on the payer side. Hence, to eliminate the exchange rate risk, the payer buys a forward contract, or a future contract or a call option.

Let's say the exchange rate today is 1.5 A$ per US$. The payables is $A 1 million or equivalent (1/1.5) = 0.667 US$

Now let's day the exchange rate after 90 days is 1.4 A$ per US$. The payables of $A 1 million becomes (1/1.4) = 0.714 US$

Hence, to hedge this risk we lock in a fixed rate using forward and future contract, so that on expiry irrespective of the prevailing exchange rate, we would be able to exchange dollars at the fixed pre-determined rate. Both the forward and future contract have the same mechanism, the difference being forward are over the counter. Hence, forward would carry a greater counter-party credit risk where as futures being standardized, would face no risk.

Similary, for hedging using call options, we buy a call option on A$ at the strike price equal to the current exchange rate and maturity at 90 days. Due to this any loss due to the A$ appreciation would be hedged as the call option would have a positive payoff when A$ would appreciate.

What are the pro and cons of using each FX derivative in general

Forward contract Pros -

No upfront payment is required to enter the contract

The forward contract tends to be cheaper to hedge than an option or a future

Forward contracts can be customized according to the requirements of the parties

Forward contract Cons-

Forward contracts are over-the-counter contracts. Hence they carry a counter-party credit risk, ie the other party to the forward contract may default.

The potential loss is unlimited depending on the price of the underlying at maturity.

Future contract Pros -

No upfront payment is required to enter the contract

The future contract tends to be cheaper to hedge than an option

Negligible counter-party credit risk, as the contract are traded on an exchange

Future contract Cons-

Relatively expensive than forwards

The potential loss is unlimited depending on the price of the underlying at maturity.

Options Pros -

Options being traded on an exchange have negligible counter-party risk.

Options are less-risky as the downside is capped to the amount of premium paid for purchasing the option.

Options Cons-

In general, they are more expensive for hedging FX than forwards and futures

In options contract the premium is to be paid up-front