In: Finance
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?
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 |