Question

Comment on advantages/disadvantages of each of the SIX payment alternatives / hedging strategies.

Answer 1

HEDGING

Hedging is a risk management strategy. Working on the principle of offsetting, it is a process of taking an equal and opposite position in two different markets, thereby compensating the potential losses to be incurred from one investment . Hedging can be classified into three, which are:

1. Forward contract

2. Futures contract

3. Money markets

1. Forward contract: It is the type of contract wherein the parties enter into a contract for a future date at the current or pre determined price. This is to eliminate the risk of loss in the future due to the fall in the price of security.

Advantages

i) It provides price protection

ii) They can be matched against the time period of exposure.

iii) They can be matched against the cash size of exposure.

iv) They are tailor made

v) It offers complete hedge

vi) They are easy to understand.

Disadvantages

i) It is subject to default risk.

ii) It may be difficult to find a counter party.

From the datails given above, it is understood that forward contract provides complete hedge, but the disadvantage of this contract is that it is hard to find a counter party to the contract. All the advantages makes it an appropriate contract for hedging but the difficulty in finding a counter party makes it a tiresome contract.

2. Futures contract : Futures are contracts where the parties enter into a contract at a predetermined price in the future.

The claimable advantages of the contract include:

i) Easy pricing of the security

ii) High liquidity of the security

iii) It helps to hedge risk

The major disadvantages of the contract include:

i) There is on control over the future events

ii) it is not affected by positive price fluctuations

From the given advantages and disadvantages it can be evaluated that Futures are an appropriate option as per the situation. The pricing of securities is based on estimation and not real hence it is not affected by any positive events in the future.

3. Money market : Money markets are the short term markets for buying and lending of short term financial instruments. It reduces the risk of price fluctuation of a currency in a spot transaction by a contract beforehand in the predetermined currency or financial instruments. The greatest advantage of this hedge is that it helps in easy trading of securities and meeting day to day operations of the firm.