Question

Outline the key features of currency forward contracts and compare this with one internal method of hedging against currency exposure.

Answer 1

A currency forward contract is a contract of exchange of one currency with another at a certain exchange rate at a future date. By using the currency forward contract, parties are able to lock the exchange rates for a fixed future date.

Key features of the currency forward contracts are:

1. The agreement between the parties is not public, it is private between them.

2. Contracts are exposed to risk of counter party.

3. Forwards are not traded on any public exchange.

4. Exchange rate for a fixed future date is decided in this currency forward contract.

One of the internal method of hedging against currency exposure is currency risk sharing. Currency risk sharing is a hedging method where two parties decide to share the risk of exchange rate fluctuations. Risk is shared in this method and one party benefits at the cost of the other.

In currency forward contract, risk is not shared, only one party bears the risk but in currency risk sharing, risk is shared between the two parties.