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- 5 Marks
Question
c) Explain TWO (2) advantages to a company dealing with a currency risk exposure using a forward market hedge as against a futures market hedge. (5 marks)
Answer
- Tailor-Made Contracts:
- Forward contracts can be customized to meet the specific needs of a company in terms of contract amount and maturity. This allows a company to hedge exactly the amount it requires for a specific period, aligning the hedge with the company’s cash flow needs. In contrast, futures contracts are standardized in terms of contract size and maturity dates, which might not align perfectly with the company’s specific exposure, leading to inefficiencies in hedging.
- Absence of Margin Requirements:
- Forward contracts do not require margin payments, whereas futures contracts typically require the posting of initial and maintenance margins. This means that with forward contracts, the company does not have to tie up cash or other assets as collateral, which can be particularly beneficial for cash flow management. The absence of margin calls reduces the financial burden on the company, especially in volatile markets where frequent margin adjustments might be needed in futures contracts.
- Flexibility in Settlement:
- Forward contracts allow for flexibility in settlement, as they can be settled either by actual delivery of the currency or by a cash settlement, depending on the terms agreed upon. This flexibility can be advantageous to a company that may prefer to settle in cash rather than having to deal with the logistics of currency delivery. On the other hand, futures contracts generally require a cash settlement or physical delivery as per the standardized terms, which might not be as convenient for the company.
- Tags: Currency risk, Forward market hedge, Futures Market Hedge, Risk Management
- Level: Level 2
- Topic: Foreign exchange risk and currency risk management
- Series: MAY 2021
- Uploader: Uploader1