Commonly Used Financial Hedging Techniques - Forward Contracts, Future, Market Money and Option - Case Study Example

DRAFT The four commonly used financial hedging techniques include forward contracts, future, market money and option. The corporate world has expanded rapidly over the last two decades and carrying out business has become a very complicated issue due to the unpredictable business environment. Any business if faced by risks during its operation despite its location , method of location or the services or goods it offers to its consumers. Due to this exposure to risk the management of every organisation requires to be well informed on the methods of risk management to avoid subjecting the institution to situations that would risk its closure. Hedging techniques are mainly used in anagement of risk and hedging is defined as any strategic measure that the management implements to limit the probability of loss due to risk occurrence. It involves offsetting any situation that would lead to loss from situations such a price fluctuations, currency value fluctuation or insecurity . Most companies manage risk by buying insurance policies but hedging deals with transferring the risks that are bound to occur without necessarily buying any insuarance policy. Companies spend alot of money in insuring risks and this reduces their profit margins and in most cases this risks do not occur over any years. The introduction of hedging techniques came due to the issue of cost on insuarance on risk that are manageable by the organisation. There are four major types of hedging techniques used in organisation and do not depend on the organisation size or the product or service they produce. This methods are universal and they are, forward contracts ,future,market money and option, and they have been tested all over the world and provided positive results. Although this methods have differences, they all involve the management of an organisation being able to take two different and opposite positions in two different markets such as cash and future markets. The organisation could also use the hedging techniques to protect their capital against unavoidable risky situations such as inflation by investment in high yielding instruments of finance. foward contracts foward contracts are one of the most derivatives used in heding of risks since it is an arrangement by the organisation with another party or an individual with another party to make a transaction at a particular tome at a particular price.im such a situation the buyer and the seller commit themselves to a contract that will happen at a particular time in the future but the contract is made earlier. The terms of the contract are ependant on themarket situation at the moment and any changes in the market will not affect the contract that was ealier made.the main reason as to why companies and corporations use future contracts is to offset the risks that would come about as a result of fluctuations in the market price of the commodity they are purchasing. The ultimate goal of any management that employs future contracts as a heding tool is to ensure that they escape any extra cost that could be incurred in purchase of a commodity or a service that they intend to buy in future due to changes in its price. However in real life situations this hedging tool is almost impossible since any companies will not be willing to comit themselves into a contract following the highly dynamic state of markets today. Such commitments lead to do or die situations to a company since they would either bring profits to them if in future the prices will have hiked or either bring losses is the prices will be lower that the price at the point of making the contract. Hedging using foward contracts takes two forms which are long position and short position. Assuming a company A are willing to purchase an item in the future , they should take the long position in the future contract. Company A is willing to spend 100$ to purchase a certain machinery in their firm in the next 8 moths. If the current price of the machinery is 100$ they would negotiate with the supplier to sell to them the machinery in future price of 90$. When the deal have been striken, the company reduces the chances of risking to the buy the machinery at a higher price after the next eight months. On the other hand if the company is willing to sell a machinery they already have but will not be using it after eight months , they take the short position in the future. The company A will look for a buyer at the moment and agree to sell the machinery at a set price. The company benefits in such a way that they will avoid the chance of selling the machine at a lower price after eight months are over. Foward contracts are very benefitial to a company since they limit the risk the investor will be exposed to due to involvement in trade. Its main advantage is reduction in the uncertainities of future prices buy locking prices for items they are willing to buy or sell. Future contract Future contracts are more similar to the foward contract although they differ in some ways since the future contract are exchange traded and therefore are standardized contracts as opposed to the foward contracts that are private agreement among two parties. A future contract is more rigid than a foward contract that has chances of one party defaulting on their side of the agreement. A future contract is defined a a contractual agreement between two parties that is made on the trading floor of future exchange to buy or sell a particular commodity or a financial tool at a predetermined price in the future. Before any furure contract is made, the details of tha commodity in question in terms of quality and quantity are standardized to facilitate trading on a future exchange. Depending on the agreement of the two parties involved in the contract, the item in question may physically be delivered or settled in cash. Assuming that a company X wishes to purchase a commodity from a company y at a price of 50$. The company x will fill the details concerning settlement and deliver with company Yafter the agreement is made company x will begin to pay for the commodity on daily basis or else as agreed between the two parties. A future contract is market-to-market daily since the specific price agrees is settled in bits every day. In the example above the 50$ will be divided into daily charges depending on the duration of time agreed on the contract but it has a requirement that the full amount is settled before the day of exchange is reached. Future contracts are more binding and no party has the chance of foregoing the agreement since the implementation of the contract starts immeadiately the contract is agreed upon. A future contract would benefit the company in such a way that they purchase the commodity at certain price now although it will get into their full ownership at a later date when the agreement is full settled. The price initially agreed does not change with any changes in the market and hence the company is able to escape costs of inflation or market fluctuations. market money Any business in international operation is exposed to foreign exchange risk but can be hedged using money market. This method of hedging is however mostly used by small organisations since large organisations have more economical ways to hedge the foreign exchange risk through measures such as currency futures and fowards. The aim of a market hedge is to help domestic companies reduce the risk they are bound to get exposed to when they do business with a roregn company on an international market platform. Money market allows local company to lock in their partners currency in advance of a planned future transaction creating certainity on the future transactions cost and assures the local company of ability to pay during the transaction. A money market hedge protects domestic companies from exchange rate fluctuations that would alter the transaction price in such a way that would kick the company out of business. Although the fluctuations would also lead to the company being able to purchase more or sell more, hedging using the money market remains important to protect the business if the opposite happens. Assuming a situation where a company B that is located in the united states wishes to carry out a transaction with a company C that is located in Russia. If the company B wishes to purchase commodities from company C they will have to carry out the transaction using the Russia currency rather than their dollar. If the transaction is meant to happen in the next eight months , the company will use the market hedge to lock its value of the Russian currency relative to the dollar such that even in a situation when the dollars strength reduces within the eight months it will not affect their transaction. Read More