Question

Discuss the advantages and disadvantages of using forward contracts to hedge foreign exchange risks.

Answer 1

This is a contract between two parties of which one party will sell an asset and the other party will purchase it on a future specific date at a specific price.

Therefore, price and date are fixed here in advance. These create some sorts of advantages and disadvantages.

Advantages are as below:

Point 1) Exchange rate: This contract protects from exchange rate fluctuation. If two parties are from different countries, fluctuations of their currency exchange may affect spot price, which could be prevented through this contract.

Point 2) Zero-sum game: There is nothing extra – if one party gains $50 the other must loses $50. Ups or downs of exchange rate doesn’t create any impact here.

Disadvantages are as below:

Point 1) Market value: If such value of the product increases in future, the seller can’t get such value because there is a forward contract.

Point 2) Quality: If the product quality differs on future date (like the product wool), the forward contract still be executed if the minimum agreed upon quality is maintained.