Hedging Flashcards
Forward rate agreements
ADVANTAGES
For the period of the FRA at least, they protect the borrower/investor from adverse market movements
FRAs can be tailored to the amount and duration required, whereas some other hedges, eg futures are standardised
DISADVANTAGES
They are usually only available on loans of at least £50,000
They are also likely to be difficult to obtain for periods of over one year. This problem can be overcome by using a swap
They remove upside potential I.e they give a fixed rate of interest
Interest rate swaps
ADVANTAGES
They enable a switch from floating rate to fixed rate interest, or vice versa, for use as a hedge against interest rate risk
The arrangement costs are often significantly less than terminating an existing loan and taking a new one
They can be used to make interest rate savings either out of the counter party or out of the loan markets by using the principle of competitive advantage
They are available for longer periods than short-term methods of hedging risk
They are flexible since they can be arranged for tailor made amounts and periods
DISADVANTAGES
There is a risk that the counter party to the swap will default before completion of the arrangement, this risk is lessened by using a reputable intermediary
The risk of unfavourable market movements of interest or exchange rates after the company enters a swap
The risk that swap activity may lead to the financial statements of the party involved being misleading
Currency futures
ADVANTAGES
Transaction date flexibility, because the future does not have to be closed out until the stated settlement date
Exchange regulated market so counterparty risk reduced
Ease of buying and selling of contracts through a highly liquid market
DISADVANTAGES
Contracts cannot be tailored to exact requirements due to contract sizes
Limited number of currencies traded
The need to use a broker (fees)
The need to deposit and maintain a margin account
Basis risk is an issue
Currency options
ADVANTAGES
Options remove downside risk but leave upside potential
DISADVANTAGES
The cost is about 5% of the total amount of foreign exchange covered, although the exact amount depends on the expected volatility of the exchange rate
Options must be paid for as soon as they are bought
Tailor made options lack negotiability
Traded options are not available in every currency
There is no secondary market
Cryptocurrency
ADVANTAGES
Streamlines cash flow management
DISADVANTAGES
Cryptocurrency exchanges are only likely to exchange for a narrow range of major currencies
Cryptocurrency exchange rates are extremely volatile
Forward contracts
ADVANTAGES
Can be tailor made to the individuals needs
DISADVANTAGES
There is no secondary market
Money market hedge
ADVANTAGES
Can be tailored specifically to individual needs
In the case of receipts, it accelerates receiving the home currency
DISADVANTAGES
More difficult to set up than a forward contract
Might use up credit lines
