Key Difference – Hedging vs Forward Contract
The key difference between hedging and forward contract is that hedging is a technique used to reduce the risk of a financial asset whereas a forward contract is a contract between two parties to buy or sell an asset at a specified price on a future date. Since the financial markets have become complex and grown in size, hedging has become increasingly relevant to investors. Hedging provides certainty with a future transaction where the relationship between hedging and forward contract is that the latter is a type of contract used for hedging.
CONTENTS
1. Overview and Key Difference
2. What is Hedging
3. What is a Forward Contract
4. Side by Side Comparison – Hedging vs Forward Contract
5. Summary
What is Hedging?
Hedging is a technique used to reduce the risk of a financial asset. A risk is an uncertainty of not knowing the future outcome. When a financial asset is hedged, it provides a certainty of what its value will be at a future date. Hedging instruments can take the following two forms.
Exchange Traded Instruments
Exchange traded financial products are standardized instruments that only trade in organized exchanges in standardized investment sizes. They cannot be tailor-made according to the requirements of any two parties
Over the Counter Instruments (OTC)
In contrast, over the counter agreements can materialize at the absence of a structured exchange thus can be arranged to fit the requirements of any two parties.
Hedging Instruments
There are four main types of hedging instruments that are commonly used.
Forwards
(explained in detail below)
Futures
A futures is an agreement, to buy or sell a particular commodity or financial instrument at a predetermined price at a specific date in the future. Futures are exchange traded instruments.
Options
An option is a right, but not an obligation to buy or sell a financial asset on a specific date at a pre-agreed price. An option can be either a ‘call option’ which is a right to buy or a ‘put option’ which is a right to sell. Options may be exchanged traded or over the counter instruments
Swaps
A swap is a derivative through which two parties arrive at an agreement to exchange financial instruments. While the underlying instrument can be any security, cash flows are commonly exchanged in swaps. Swaps are over the counter instruments.
Figure 01: Swap instrument
What is a Forward Contract?
A forward contract is a contract between two parties to buy or sell an asset at a specified price on a future date.
E.g., Company A is a commercial organization and intends to purchase 600 barrels from oil from Company B, who is an oil exporter in another six months. Since the oil prices are continuously fluctuating, A decides to enter into a forward contract to eliminate the uncertainty. As a result, the two parties enter into an agreement where B will sell the 600 oil barrels for a price of $175 per barrel.
Spot rate (rate as per today) of an oil barrel is $123. In another six months’ time, the price of an oil barrel may be more or less than the contract value of $175 per barrel. Irrespective of the prevailing price as at the contract execution date (spot rate at the end of the six months). B has to sell a barrel of oil for $175 to A as per the contract.
After six months, assume that the spot rate is $179 per barrel, the difference between the prices A has to pay for the 600 barrels due to the contract can be compared with the scenario if the contract did not exist.
Price, if the contract did not exist ($179 *600) = $107,400
Price, due to the contract ($175 *600) = $105,000
Difference in price = $2,400
Company A managed to save $2,400 by entering into the above forward contract.
Forwards are over the counter (OTC) instruments, they can be customized according to any transaction, which is a significant advantage. However, due to the lack of governance, there may be high default risk in forwards.
What is the difference between Hedging and Forward Contract?
Hedging vs Forward Contract |
|
| Hedging is a technique used to reduce the risk of a financial asset. | Forward contract is a contract between two parties to buy or sell an asset at a specified price on a future date. |
| Nature | |
| Hedging techniques may be exchange traded or over the counter instruments. | Forward contracts are over the counter instruments. |
| Types | |
| Forwards, futures, options, and swaps are popular hedging instruments. | Forward contracts are one type of hedging instruments. |
Summary- Hedging vs Forward Contract
The difference between hedging and forward contract is mainly dependent on their scope where hedging is broader in scope as it involves many techniques while forward contract has a narrow scope. The objective of both are similar where they attempt to mitigate the risk of a transaction that will take place in the future. Further, the market for forward contracts is significant in volume and value, however, since the details of forward contracts are limited to the buyer and the seller, the size of this market is difficult to estimate.
Reference:
1. Picardo, CFA Elvis. “Forward Contract.” Investopedia. N.p., 03 Apr. 2015. Web. 04 May 2017. <http://www.investopedia.com/terms/f/forwardcontract.asp>.
2.”Forward Contract.” Investing Answers Building and Protecting Your Wealth through Education Publisher of The 2. Next Banks That Could Fail. N.p., n.d. Web. 04 May 2017. <http://www.investinganswers.com/financial-dictionary/options-derivatives/forward-contract-4892>.
3.Stock/Share Market Investing – Live BSE/NSE, India Stock Market Recommendations and Tips, Live Stock Markets, Sensex/Nifty, Commodity Market, Investment Portfolio, Financial News, Mutual Funds. N.p., n.d. Web. 04 May 2017. <http://www.moneycontrol.com/promo/mc_interstitial_dfp.php?size=940×400&website_referrer_url=%2Fnews%2Fbusiness%2Fstocks-business%2F-1727777.html>.
Image Courtesy:
1.”Vanilla interest rate swap with bank” By Suicup – Own work (CC BY-SA 3.0) via Commons Wikimedia