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Define forward and futures contracts and explain how they may be used in hedging and speculation. Explain,...

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Finance

Define forward and futures contracts and explain howthey may be used in hedging and speculation.

Explain, using numerical examples, the settlement mechanisms offorward and futures contracts and discuss how these are likely toaffect the probability of, and loss from default.

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Hedging refers to taking offsetting position in two separate but related financial instruments such that the impact of the risk factor is mitigated or eliminated A very simple example is Say a company completes a delivery today but payment will be received in a foreign currency a month later but based on exchange rate today A company should immediately hedge this position by entering into a transaction where payment by it has to be made in the same foreign currency a month later but based on exchange rate today If this happens the company receives payments in the foreign currency a month later and pays out the same amount in the second transaction thus without incurring any gains losses due to exchange rate fluctuation Hedging can be natural or intellectual man made A natural hedge is by taking offsetting positions in two securities For example Buying shares of India Cements and shorting selling shares of another cement company say J K cement A natural hedge is a method of reducing risk by investing in two different items whose performance tends to cancel each other A natural hedge does not involve the use of sophisticated financial tools such as derivatives or futures contracts Its a natural hedge Gain in one will offset the loss in other Insurance is a natural hedge An artificial hedge is by taking the offsetting position in derivative market by making use of options futures forwards or even swaps Hedging can be used to manage risks arising due to fluctuations in prices interest rate or foreign exchange rates Commonly used instruments are future contracts options Call and Put option on the stock of two different companies operating in same sector sale and purchase of rights to goods and services for delivery at different dates Uses Derivatives are used for the following Hedge or mitigate risk in the    See Answer
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Define forward and futures contracts and explain howthey may be used in hedging and speculation.Explain, using numerical examples, the settlement mechanisms offorward and futures contracts and discuss how these are likely toaffect the probability of, and loss from default.

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