/Advantages and Disadvantages of Hedging with Forward Contracts

Advantages and Disadvantages of Hedging with Forward Contracts

Futures often cover assets such as grains, beef, oil, precious metals, foreign currencies and certain financial instruments. Futures often involve buying a product that is not seen. A major problem with futures contracts for certain commodities is when the physical characteristics of the product deviate from the original promise. For example, a futures contract for wool cannot guarantee the quality of the wool at the time of delivery. Wool can be stronger one year than the next, because the quality of wool varies from season to season. Fluctuations in the quality of the product change its market price, but in a futures contract, the seller must pay the price as long as the contract stipulates that the quality reaches an agreed minimum level. Then, the disadvantage of hedging with futures contracts implies the fact that there are standardized functions. To enable trading, there must be standardized functions, as buyers and sellers never meet. This means that all futures contracts must conform to the same standard and establish guidelines. Since a futures contract has standardized characteristics in terms of certain characteristics such as the size of the contract and the expiration date, perfect coverage may not be able to take place. Since overhanging is generally not advised, a certain portion of cash transactions may remain unsecured. High leverage can lead to rapid fluctuations in forward prices.

Prices can go up and down every day or even within minutes. The advantage of hedging with futures is that it is liquid and can be traded on the central market. This means that futures can be quickly bought or sold on the central market. This is because futures can be traded on the central market, where there are many market participants. If there are a lot of market participants trading futures on the central market, it will increase liquidity as many market participants enter and exit the position, such as long and short. This will then make it easier for market participants to buy and sell futures on the central market. This also causes the trader to easily close his position by simply making a reverse trade in the central market. Some agricultural lenders use tripartite coverage agreements between the producer, broker and lender. In this agreement, the brokerage sends all margin calls to the lending institution. The lender then automatically lends the producer the amount needed to cover the margin requirements and sends the margin deposit to the brokerage firm. In this way, the corn producer is assured that funds are available for the margin account.

In the case of profits in the forward position, these are automatically sent to the lending institution to be invested in an interest account for the producer. Tripartite agreements also tend to reduce the psychological stress a producer may face when receiving margin calls. The producer receives copies of all transactions. Finally, the disadvantage of hedging with futures also includes the fact that it could do without cheap movements. This means that the right moves that generate profits for the trader are sacrificed. When hedging with futures contracts, the losses or gains from the spot transaction can be offset by the gains or losses from the futures trade. For example, if a trader believes that dollar futures will depreciate in the future, they have sold the dollar futures and expect them to depreciate. However, if the dollar goes in the opposite direction to the trader`s expectations and appreciates rather than depreciates, the trader will have to sacrifice those favorable moves. Futures are contracts whose expected futures values are currencies, commodities and stock indices. In the case of raw materials, a futures contract implies the obligation to deliver or receive a certain quantity of goods at a future time at a price in force at that time.

However, actual delivery rarely takes place on futures contracts; instead, they are closed by paying for price differences. The additional literature on hedging for maize growers results from: The disadvantage of hedging via futures contracts is that it is a legal obligation. This means that there is a mandatory act that the holder is required to perform. Indeed, futures contracts are a contract and the holder had to perform his action as specified in the contract. This legal obligation can cause difficulties for the business community. For example, if hedging is done through futures contracts for a plan that is still in the bidding process, the forward position can become a speculative position if the offer is not selected at the end. Futures are used as a hedging tool in industries where price fluctuations are high. .