The future can hardly be predicted accurately; to reduce losses likely to be caused by fluctuation of prices, the business engages in hedging transactions. Hedging is defined as the process of using derivative products to manage the risk of loss caused by fluctuation of financial prices; financial prices managed through hedging include foreign exchange rates, interest rates, equity prices, and commodity prices. There are two main options available for businesses using the hedging loss management method; they are forward contracts and options contracts. This paper discusses the advantage and disadvantages of forwarding contracts and options contracts as methods to militate against future financial losses.
Forward contacts are the oldest method of hedging; it involves a trade commitment by parties involved that agree on the price of a commodity although the actual transaction will take some time in the future.
There are numerous advantages associated with forwarding options they are:
- The contract offers full coverage in the event of a financial loss; the buyer of the option can be assured of getting his agreed amount
- The contact does not limit the duration it remains in force save to the time limits set by the parties involved.
Despite the advantages brought about by forwarding contracts, they have the following disadvantages:
- Getting a partner who is willing to engage in such a transaction is challenging to get another willing party (counterparty)
- The contracts lead to the tying of capital; the parties are tied to the contact despite clear chances of loss to one party
- Although the contract is binding to the two parties, it is subject to default
Options contracts are rights, but not obligations, to either buy or sell a specified commodity, at a specific date, at a preset price; the commodities likely to be sold using options contracts include Index, debt, stock, currency, or commodity. Options contracts can be classified as a call option (which offers the contracting parties the right to sell) and a put option (which gives the right to the seller of a commodity in question.
The following are advantages of holding options:
- Options are the most cost-effective method of managing future financial risks; they have leveraging ability
- When managed effectively, options can control risks fully; they are dependable and give the holders room to negotiate their way through the contract
- Option contracts have high chances of giving the holders high returns
- When holding option contracts, the parties to the contracts have the room to make other strategic alternatives as the contract does not limit doing so.
Disadvantages of option contracts
- The contracts are not flexible as they have predetermined rates and time through which they will be enforced
- The contracts are subject to basis risk and there is not much liquidity on the part of the owners
- The options give the chance for either party to partially hedge their financial loss; there is no certainty that the entire amount will be covered (Cheol & Resnick, 2008).
The preferred hedging method
Considering the advantages and shortcomings of option and futures contracts, futures contracts are better as they are able to manage financial loss fully. The other advantage they have over future options is that they have no time limit other than the time set by the parties; parties have the power to amend the maturity period.
Cheol, S., & Resnick, B. (2008). International Financial Management. London: McGraw-Hill/Irwin