Advantages and Disadvantages of Forward Contracts - Essay Example

The first advantage of using forward contracts to hedge foreign exchange risks is that future rates can be fixed in advance. This, therefore, eliminates the downside risk exposure. Secondly, forward contracts are more flexible concerning the amount of money to be covered. Thirdly, forward contracts are relatively simple and straightforward to both comprehend and organize (Feng, 2007).

On the other hand, options allow the contracting party to settle forward contracts at an agreed and fixed exchange rate, but at any time between two specific dates. This means that option-date forward exchange contracts can be settled at the agreed rate if currency cash-flows occur between the two set dates (Meera, 2009).

Although forward exchange contracts are simple agreements that can mitigate exchange rate risks, they have some shortcomings. In particular, it may be difficult to get a counterparty who will agree to fix future exchange rates for the period as well as the amount in question. Secondly, forward contracts do not provide an opportunity for the parties to benefit from favourable fluctuations in the exchange rates. Thirdly, forward markets only exist for major world trading currencies such as the Dollar, Euro, Pound or Yen, but they do not exist for exotic currencies (Doupnik & Perera, 2007).

The main disadvantage with options is that the issuer of the option receives the fees upon the specified date and is obligated to buy the securities at the other party’s option. Additionally, options are subject to basis risks and only provide a partial hedge (Meera, 2009).

Accounts receivable [1,000,000 x $0.088]                           $88,000.
Accounts receivable                                                              $88,000.
[Accounts receivable [1,000,000 x ($0.088- $0.084)]         $4,000.
Foreign Exchange Gain                                                        $4,000

Accounts receivable [1,000,000 x ($0.080-$0.074)]                        $6,000.
Foreign exchange gain                                                          $6,000.
[1,000,000 x ($0.080- $0.074) = $6,000 x 0.9803 = $5881.8]         $5881.8.
Forward contract                                                                               $5881.8.

Sales                                                   $88,000.
Foreign Exchange gains                      $4,000.
Foreign Exchange gains                      $6,000.
Premium revenue                               $5,881.1.
Total                                                   $103,881.1.