Risk Financing: Analysis of Foreign Exchange Derivatives Strategies

This report provides a comprehensive overview of risk financing using foreign exchange derivatives. It begins by introducing the concept of foreign exchange and the associated risks faced by businesses in international trade. The report then delves into various types of derivatives, including forward contracts, futures contracts, options contracts, and swap contracts. For each type, the report explains the basic features, merits, and demerits. Forward contracts are presented as agreements for future transactions, highlighting their role in hedging and risk management but also acknowledging the risk of non-performance. Futures contracts are discussed in terms of their standardized nature and ease of access, along with their leverage and price volatility. Options contracts are examined for their cost-effectiveness and marketability, as well as their complexity and time decay. Finally, swap contracts are described as tools for managing currency fluctuations, emphasizing their benefits for both parties involved, while also mentioning the challenges in finding suitable counterparts and the associated costs. The report references several academic sources to support its analysis.

RISK FINANCING

INTRODUCTION
• The financial markets are everchanging and therefore to counter the risks
which are involved in foreign exchange transactions, foreign exchange
derivatives are used by businesses. Most of the countries and traders are
engaged in foreign exchanges and the same leads to globalization (Hudson
2017). In financial markets, trade involving foreign exchange is very
common and this has opened new dimensions for businesses across the
world. The foreign exchange trade involves use of currency of foreign
countries which fluctuate on regular basis and therefore there is significant
risk on businesses due to such factors.

DISCUSSION
• A derivative is an instrument whose value depends on the values of other
more basic underlying variables. Any financial market instrument which can lock in
foreign exchange rates and there also minimize the risks of fall in the value of currency are
known as foreign exchange derivatives (Hirsa and Neftci 2013).

TYPES OF DERIVATIVES

FORWARD CONTRACT
• In a forward contract situation, an agreement is made between two parties
for either buying or selling a product at a specific price, however, the actual
transaction takes place at a future date and this a main feature of a forward
contract (Wong 2013).
• The benefit of forward contract is that the same allows the investors to lock
in the product or the assets which the other party wants at a specific price
when the agreement is made (Boroumand et al. 2015).

MERITS OF FORWARD
CONTRACTS
The advantages which can be pointed out for forward contract are given
below:
• Forward contracts can be used as an instrument for managing the risks of
the foreign exchanges and can be effectively used as hedges in industries
such as agriculture.
• Another important benefit which can be identified for forward contracts is that the instrument
gives immense protection against risks of fall in prices of a product or asset (Bielecki and
Rutkowski 2013).
• Forward contracts such as the same are easy to set up and maintain and
are particularly inexpensive in nature.

DEMRITS OF FORWARD
CONTRACT
The demerits which can be identified are listed below:
• The main disadvantage which can be pointed out regarding forward
contracts is that there is always a possibility of non-performance of the
contract which can lead to serious losses for the parties
• Forward contracts often in many cases covers agricultural products and
precious metals trade. Therefore, in many situations the product which the
buyer is suppose to purchase is not seen till the contract date. This creates
a huge risk regarding non-performance of the contract.

FUTURE CONTRACTS
• A futures contract is an agreement to buy or sell an asset at a certain time
in the future for a certain priceBy contrast in a spot contract there is an
agreement to buy or sell the asset immediately (or within a very short
period of time)

MERITS OF FUTURES
CONTRACTS
• Future contracts can be obtained easily by the investors and a much larger
amount can be invested in a future contract for the purpose of investment.
• Future contracts are traded on regular basis in financial markets and
therefore the derivative is considered to be highly liquid in nature
• Futures have low margin requirements.

DEMRITS OF FUTURES
CONTRACT
• Future contracts generally uses leverage in order to maximize the returns
and make the investment attractive. However, the same can also going in
adverse manner and the riskiness can enhance accordingly
• Future contracts are traded on a continuous basis and therefore are
applicable in short run. The prices of futures contracts are changing on a
regular basis and therefore the prices need to be monitored regularly which
is a rigorous process.

OPTIONS CONTRACT
Options contracts are a type of derivatives which allows the businesses to
enter into an agreement which allows buyers and seller to have a right to
option to purchase or sell the product at an agreed price. Such options are
generally applied to securities, commodities and real estate transactions. In
case of an option, buyers have the right but does not have any obligation to
buy or sell

MERITS OF OPTIONS
CONTRACTS
• One of the main advantages of using an option contract, is that the
contracts are every much cost effective in nature. Options can be said to be
an inexpensive technique to gain access to underlying investments without
having the need to purchase any stocks. In addition to this, option allows
individuals to stump up less amount of money and end with more gains
(White 2014).
• The options contracts are easily marketable in the financial markets.
Options can be traded freely in the market and also are standardized. In
addition to this, option contracts also facilitate hedging which allows the
individual to effectively manage the risks of the business and also make
gains for the individual from the options contract.