Gaining a better understanding of derivative securities with regard to hedging opportunities is essential in today’s financially-driven market. Financial derivative securities are used by many businesses to protect against risks or to profit from them. A company interested in protecting against the risk of some event would be engaging in hedging activities while one seeking to profit from a future event would be speculating (Eiteman, Stonehill, & Moffett, 2010).
Hedging and speculation activities can be used against various types of risks faced by companies including those associated with interest rates, costs of commodities, and currency exchanges. Bartram, Brown, and Conrad (2011) discovered firms can also significantly reduce
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Some standardized terms for the IMM include contract size, exchange rate terms, margins, settlement, and counterparty agreement (Eiteman et al., 2010). A company expecting foreign currency values will rise in the future would take a long hedge position and buy a currency futures contract hedge with future currency agreement to protect against a loss (Eiteman et al., 2010). Conversely, a company expecting a fall in exchange rates would take a short hedge position (Eiteman et al., 2010). For example, if an exporter is expecting a payment in three months of $100,000 and a decline in the exchange rate, he would take a short hedge position and sell a currency futures contract with a maturity of three months from now. Let’s assume the contract settlement price is CNY 0.16/$1, a single contract is for $100,000, and the spot rate at maturity is CNY 0.13/$1. In this case, as noted by Eiteman et al., (2010), the exporter’s short position contract value at maturity would be
Value at maturity = -Notional principal x (Spot rate – Futures rate) = -$100,000 x (CNY 0.13/$1 – CNY 0.16/$1) = $3,000
Total transaction value = Payment received by exporter + futures contract value = $100,000 x CNY 0.13/$1 = $13,000 + $3,000 = $16,000
Without the hedge, the exporter would have received only $13,000 if the exchange rate declined from CNY 0.16/$1 to CNY 0.13/$1 in the three months. Additionally, if the exchange