Glossaire

An open forward contract is a contractual agreement to buy or sell a specified amount of one currency against payment in another currency on or before a specified date in the future known as the ‘value date’. By contrast, when both parties are legally obliged to exchange the funds on the value date, the forward contract is said to be’ closed’ or ‘standard’. In an open forward contract, the funds can be exchanged in one go (“outright”). Alternatively, several payments may be made over the course of the contract provided that the entire amount is settled by the maturity date. For example, a US company knows it will have to pay a number of invoices from a supplier based in the Eurozone during next year. I can decide to purchase a 12-month open USD-EUR forward contract, allowing it to make drawdowns to pay the supplier in euros, as and when necessary, over the course of the year.

In FX hedging with futures contracts, the optimal hedge ratio is the number of futures contracts required to hedge a given exposure. As an example, a Candadian farmer has signed a contract to sell 800,000 pounds of live cattle to a U.S. supermarket in three months’ time, at USD 1.65/pound. The spot USD-CAD rate is 1.1111. What number of contracts should be used to hedge the resulting CAD 1,466,652 exposure? If contract size is CAD 100,000, then the farmer should buy 14.7 contracts, which is then rounded to 15.

An outright forward contract is a contractual agreement to buy or sell a specified amount of one currency against payment in another currency at a specified date in the future known as the ‘value date’. By contrast, when both parties can exchange the funds before the value date, the forward contract is said to be ‘open’. Sometimes known as a ‘fixed’ or ‘standard’ contract, the outright forward is the simplest type of forward contract. For this reason, these forwards are widely used by businesses to hedge against the risk of losses due to adverse exchange rate movements. However, hedging with outright forwards makes it impossible to benefit from advantageous exchange rate movements. Outright forwards also offer no flexibility about the date of settlement. Both parties are legally obliged to exchange the funds on the value date. Businesses that need more flexibility over payment terms may prefer open or ‘flexible’ forward contracts.

Over-hedging describes the situation of a firm that has hedged in anticipation of an exposure that has failed to materialise completely. Over-hedging is common in companies with low forecast accuracy that apply static hedging, with a big hedge taken at the start of the period. If these positions. Firms that find themselves in a situation of over-hedging should unwind some of their hedges in order to free up collateral and increase the firm’s borrowing capacity—a top-priority in situations of stress in credit markets. Over-hedging can be overcome with the right budget hedging program or combination of programs that mix elements of static and dynamic hedging.

Over-the-counter derivatives (OTC derivatives) are financial contracts —such as forwards, swaps and options— that are traded through a dealer network rather than through a centralised exchange. The lack of an exchange that guarantees all trades means that the parties to an OTC transaction are exposed to counterparty risk. While currency forward contracts are ‘over-the-counter’, futures contracts are ‘exchange-based’. Most companies, when hedging their FX exposure, rarely choose futures contracts. Instead, they rely on over-the-counter forward contracts, which are used in Currency Management Automation solutions.