Discussion for hedging

Forward contract can be tailormade, perfectly hedge

- Default risk higher than exchange traded

- Obligation (protect from loss but cannot enjoy the favorable movement)

Futures

- Low default risk compare to forward contract bcs exchange traded is highly regulated
- Obligation (protect from loss but cannot enjoy the favorable movement)
- Margin are required and the contract are marked to market
subject to basic risk lead to imperfect hedge
Option
can be tailormade
- Low default risk compare to forward contract
- Need to pay high premium
- Have option to lapse the contract and enjoy the favorable movement

Select hedging method with high receipt and low payment

Basis Risk

Basis ( the difference between the futures price and spot price). This is used to forecast the closing
futures rate on the assumption that basis decrease in a linear manner.

Basis risk is risk that basis may not decrease steadily in linear manner. This mean that the hedge
using the futures is imperfect.

Basis risk will probably be smaller than the risk exposure without hedging, therefore although
some risk will exist, its impact will be smaller.

Mark to market
1. Company have to deposit an amount (initial margin) in margin account to open the position.
2. The margin account will remain open as long as futures open.
3. Profit or loss on the futures is calculated daily and the margin account is adjusted.
4. If the balance on the margin account is less than maintenance margin, the futures exchange
will demand (margin call) for an extra payment (variation margin) to increase the balance to the
maintenance margin or initial margin.