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Differentiate hedging and forward contract
Financial markets are complex and large in size. Before going for differences let us try to understand the terms hedging and forward contract in brief.
Hedging
It is the technique which is used to reduce the risk of financial assets. Risk of uncertainty of future income is involved. By hedging they can be certain about future value and date.
Some of hedging instruments are as follows −
- Exchange traded instruments: only traded with standardized investment sizes in organized exchanges.
- Over the counter instruments: structured exchange is not present or no structured exchange.
Commonly used hedging instruments are forwards, futures, options and swaps.
Forward contract
Let us try to understand the forward contract with an example.
A commercial company purchases 500 barrels of crude from an oil exporter company in 6 months. Since crude prices fluctuate daily. To eliminate risk, the commercial company made a forward contract with the Oil Exporter Company.
An agreement is made between the companies for supply of crude of 500 barrels for $150 per barrel. Let us assume the spot rate of crude is $115. In the next six months crude price may be more than $150 or may be less. Irrespective of price in next six months commercial company has to pay $150 per barrel to buy 500 barrels as per agreement. (Let us assume crude price after 6 months went to $160)
As per agreement
Commercial company has to pay ⇒ 500 * 150 ⇒ $ 75000
As per current price
Commercial company has to pay ⇒ 500 * 160 ⇒ $ 80000
By entering the agreement commercial company save $5000 (80000 – 75000) (Not always same scenario repeats, but sometimes companies may go for loss also)
Differences
The major differences between hedging and forward contract are as follows −
| Sr.No | Hedging | Forward contract |
|---|---|---|
| 1 | It is a technique used to control the risk in financial assets. | It is an agreement between two parties to buy/sell an underlying asset on a future date at a particular date. |
| 2 | It may be an exchange trade/over the counter instruments. | It is an over the counter instrument. |
| 3 | Popular hedging instruments are swaps, forwards, options and futures. | It is one type of hedging. |
| 4 | It has a broader scope as compared to forward contracts. | It has a narrow scope as compared to hedging. |
| 5 | The main objective is to mitigate risk. | The main objective is to manage risk. |
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