Q. Explain the terms hedge, long position, and short position in the context of managing financial institutions’ risk. What are the pros and cons of forward contracts?
A. Hedge: Hedging transactions are executed to reduce or eliminate the price volatility risk of an asset in the exchange market (Amadeo, 2020). We ‘’hedge’’ our risk by fixing the exchange rate or the price.
Long position: Long position is a contractual obligation to take delivery of a financial asset. When a financial institution buys an asset in the exchange market, it takes a long position.
Short position: Short position is a contractual obligation to deliver a financial asset. When a financial institution sells an asset in the exchange market, it takes a short position (Mishkin 2004).
Pros and cons of forward contracts:
- Flexibility is the biggest advantage for forward contracts. They can be as flexible as much the parties want. For instance, a financial institution can create a hedge facility for hedging an interest rate risk completely.
- They are relatively straightforward to comprehend and organise (Kaplan, 2020)
- It may be hard for a financial institution to find another party to make a specific type of forward contract. There aren’t many parties that want to, or that can, involve in forward contracts. Besides, even if they find a counterparty to match up with, they may not get the price as they want because the limited number of parties in the market limits the competition, and so the ability to get a good price.
- Another disadvantage of forward contracts is that they’re subject to default risk. Supposing that two parties enter into a forward contract, if interest rates go up in the course of the contract, one party may decide to default on the contract because they can now buy other financial assets at a lower price than the price of a forward contract. They may think what’s the point of staying in the contract?
- In relation to the above point, if one party goes bankrupt in the course of the contract, the counterparty may suffer from this severely because there’s no external organization guaranteeing the contact, the only option they have now is to go to courts and sue the counterparty (Mishkin, 2004)
Amadeo, K. (2020). Hedging and How It Works With Examples. Retrieved August 7, 2020, from https://www.thebalance.com/hedge-what-it-is-how-it-works-with-examples-3305933
Kaplan (Ed.). (2020). Forward Contracts. Retrieved August 7, 2020, from https://kfknowledgebank.kaplan.co.uk/forward-contracts-
Mishkin, F. S. (2004). The economics of money, banking and financial markets. Harlow, Essex: Pearson Education Limited.