Hedging is a planned use of financial instruments or market strategies to offset the risk of any adverse price movements (Buehler et al. 2019). The hedging method limits one's loss to a known amount if the asset loses value. Discussed below are some of the hedging option with their advantages and disadvantages:
Forward contract: This is a designed agreement between two parties involved to purchase or sell an asset at a price that has been set out on a future date (Wagner et al. 2019). The forward contract uses hedging because of its non-standardized nature. Uncertainties about the exchange rate changes are eliminated by forwards to curb any losses from adverse market movements. The advantages of the forward contract include: Forwards can be understood easily,
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Forward can provide price protection, Forwards are agreeable and can be written for any term and amount. Disadvantages of forwarding contract: Forwards are subject revert risk, Forward needs capital to try up to initialize; hence no intermediate cash flow before
The settlement, Cancellation of the contract can be difficult.
Options contracts: Option contract involves an understanding connecting the buyer and the seller that makes the buyer have the right to buy or sell a specific asset at an expiry date and exercise price (Gonon et al. 2019). The agreement is usually used for commodities, securities, and real estate transactions. Options are obtained by purchase as a form of compensation. The option contract advantages include: Options can be less risky than equities, Options give several strategic alternatives, and Options have low capital requirements. Disadvantages of options contract include: The option may not be available for all the stocks; options have higher commissions.
A forward contract is preferred when the buyer wants to have an obligation to buy or sell an asset at a future date, while the option contract is selected when the buyer wants to have the right to buy purchase at a set price on or before a set date.
References
Buehler, H., Gonon, L., Teichmann, J., & Wood, B. (2019). Deep hedging. Quantitative Finance , 19 (8), 1271-1291.
Batten, J. A., Kinateder, H., Szilagyi, P. G., & Wagner, N. F. (2019). Hedging stocks with oil. Energy Economics , 104422.
