Suppose that you intend to hedge a CHF cash flow that is expected to materialize sometime...

Suppose that you intend to hedge a CHF cash flow that is expected to materialize sometime within the next three months. You are contemplating whether you should:
a. use a forward hedge by contacting a bank and setting up a forward contract on CHF that expires in 3 months, or
b. use a futures hedge by trading CHF futures on the futures exchange in Chicago.
What are the factors that will lead you to prefer one versus the other alternative?

Solutions

Expert Solution

There are a few things to consider before deciding which option to opt. Now first is the certainity of the time in which CHF cash flow is received. Another is certainity that the cash flow is actually received or not. The counter party risk or default risk is also an important factor. The margin to be paid in case of Futures Contract

Now lets weigh both the options on this factors

Factors	Forward Hedge	Futures Hedge
Time certainity	if time is not certain then it would be difficult to set a predefined date in advance when the CHF is received. In this case we face the risk of unavailability of the fund if the CHF Cash Flow is not received	Even if it is uncertain the futures transactions can be extended for a longer time period
Cashflow certainity	If the Cashflow is certain then Forward Hedge is best but if it is not then the there is a chance default risk on our side	Even if the payment is not received then we can just square off the position and take up loss or profit in the transaction
Counter Party Risk	In this case Bank might default	In this case clearing houses are the intermediary so it would be very less risky
Cost	The Cost of Forward Hedge is the cost incurred in executing the contract	In this case a marked to market system is in place where you have to pay a margin amount and with movement of the price you have to add margin. Thus this can be a costly affair if the amount is too big as capital would be required to buy futures
Regulation	The price will vary and negotiated and unregulated	The price will fixed and regulated
Gaurantee	None	Yes due to mark to market
Size	The contract size is customised	The Contract size is fixed thus we may not be able to hedge properly
Transaction	Over the counter	On exchange

jeff jeffy answered 1 year ago

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