Question

How are forwards and/or futures used and what is an advantage and disadvantage of their use from a company perspective. From an investor perspective? Discuss the importance of Forwards and Futures as they pertains to a MNC giving an example of its use. Do you support their use and why? Try to provide a real example.

Answer 1

Forwards and futures are financial derivative instruments which are typically used by the corporation to hedge the risk associated with volatility in currency exchange rates or prices of commodities. Using forwards and futures, corporations can lock in future prices of a currency pair or a commodity thus providing greater predictability in their business processes and reduce variability in their profit and loss account.

The disadvantage is that future or forward comes at a price and the future price gets locked in, so if there is a favorable movement in the future prices, the corporation is not able to gain from that movement.

From an investor perspective, future and forwards allows people to trade on stock markets and use leverage to realise bigger gains than is possible while trading on stocks alone. It also allows hedging of portfolio risks. The disadvantage is that since there is leveraged trading possible, so there is a potential for a large loss as well which might materialise.

For a practical example, consider a US based corporation with operations in Europe and India. Now the business operations are such that it imports raw materials from India and manufactures in USA and exports to Europe where a large portion of revenue is generated. To hedge against currency movement, it would enter into forwards or futures contracts for currency pairs involving Dollar/Rupee and Dollar/Euro such that it is able to reduce variability and ensure that currency movement have minimal impact on the profit and loss of the company.