Essentially forward contracts are executed over-the-counter (OTC) basically because those contracts are more conveniently executed through telephone and online trading activities in worldwide without any trading place or transactions.
The asset in this instance is the currency of a country. In the same manner currency futures involve agreements by two parties to deliver and accept a financial asset on a future specified date. The difference between the two is based on the fact that Forward contracts are traded over the counter, i.e. they are fixed contracts which are not subject to any exchange. On the other hand currency futures are subject to exchange trading. Therefore they are standardized and need to be carried out through a party that would accept the exchange. Currency futures thus involve a margin while forward contracts have no such margins. Since currency futures are based on exchange the degree of risk is mitigated while forward contracts carry a greater degree of risk.
For example, if the interest rate in the United States is 7%, then the future value of a dollar in 1 year would be $1.07. Thus Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter. Therefore in the case of physical delivery by the subsidiaries of the TIR Plc, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.
The parent company in the UK is expecting $1.4 million by 1st of December, i.e. after three months from its US subsidiary. Thus according to the interest rate futures the sum of US dollars received by the parent company would be:
$1.4m X 1.6280 = $2.2792 because at the end of the three month period the US dollar would be worth 1.6280.
(b) Discuss the merits of using forward contracts and financial futures to hedge currency risk. (20 marks)
As in the investment related practices in the money market, currency hedging involves both benefits and drawbacks and those differ with reference to some factors including trading style, investment preferences, market changes, other risk-minimizing practices and trading goals (Hsin, Kuo, & Lee, 1994). Thus the benefits that are obtainable from managing the currency risk by adopting hedging practices would not be similar to all investors. However there can be identified some benefits and drawbacks of currency hedging strategy as pointed below.
The main benefit of currency hedging is to minimize loss and risks to the investor. It is a great method to deal with international investment opportunities (Black, 1989). Even though such good risk protection methods are incorporated the