Hedging In Currency Trade Research Assignment Paper (Essay Sample)

Hedging In Currency Trade
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Hedging In Currency Trade
Most investors in the financial market risk losing their investment due to the fluctuations in prices in financial markets. To manage these risks, most investors seek to insure their investments through hedging that is used in limiting or offsetting the probability of loss due to fluctuations in the financial markets. Hedging transfers the risks without buying insurance policies. In doing so, investors can hedge through buying option contracts or forward contracts (Graham, 2014).
Option contracts are financial derivatives that give an investor an option or choice to buy the currency but one is not obligated to do so. Option contracts are set into two categories; call options which are bought by an investor who feels that the price of a certain currency mighty go up in the future and put option if the investor feels the price will go down in the future. When hedging in the option contract, an investor calls and pulls at the same time. It should be noted that if the price action falls when an investor had called, the investor will make a loss but not as much as he could have if he had not hedged his or her investment (Logue, 2016).
Option contracts have the advantage of being very cheap, they are easily available and its risk is limited to premiums only. Option contracts also have a very high potential returns than risks and they have lots of strategies to speculate on volatility and price movements (Logue, 2016).
However, option contracts have the tendency to be illiquid which is a disadvantage to the investor. They can also quickly become worthless and if one happens to be a seller, the risk is potentially unlimited( Logue, 2016).
On the other hand, forward contracts are used by large financial institutions to hedge themselves against financial exposure in foreign currency exchange due to financial price fluctuations. To hedge using forward contract, a financial institution opens two accounts, one for spot transactions and the other for hedging. If during financial exchange transactions after spoting the prices fluctuate against the speculation of the financial institution, there will be minimal loss due to the institution’s forward contract. Forward contracts offer no upside price if the exchange rate moves in your favor and a deposit is required to cover any potential market moves. Also in forward contracts, currency forwards must be settled although they can be rolled over or drawn down at a cost (Suresh & Paul, 2010).
Some of the advantages of forward contracts are; low margins, high liquidity, costs are very low, and have potential to profit without taking delivery. Some of the disadvantages include; it is mainly paper work based, set amounts traded in lots, losses can exceed a financial institutions’ account balance, they are restricted to professional traders, and some b...