Residual Risks in Hedging FX Forwards with Futures
Summary
The document considers a short over-the-counter foreign exchange forward hedged with a long exchange-traded currency future when their maturities differ. It identifies counterparty exposure if the forward counterparty defaults while the futures position remains subject to mark-to-market losses, and maturity mismatch exposure when the future expires before the forward, leaving the forward uncovered.
Suggested responses include buying credit protection from a third party for counterparty risk and rolling the futures hedge into a later expiry to address the timing gap. Both measures add cost, and credit protection creates exposure to the protection seller. The answer also recommends reducing the original forward position when possible, which lowers exposure and can avoid repeated hedging. The discussion is qualitative and does not quantify hedge ratios, basis risk, margin liquidity, rollover costs, or the legal and operational details of credit protection, so it is not a complete hedge design.
Key ideas
- A default by the OTC forward counterparty can leave the futures hedge exposed to losses.
- Different maturities create an uncovered forward exposure after the futures contract expires.
- Rolling futures to a later expiry can maintain the hedge but adds cost.
- Credit protection may address counterparty risk while introducing exposure to the protection seller.
- Reducing the underlying forward position can lower the risk that needs to be hedged.
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Full text
# Futures hedging for FX # Futures hedging for FX What is the risk that occurs if an investor hedges a short OTC foreign exchange forward sale with a long exchange traded foreign exchange futures with different maturities. And how can the residual risk be hedged? ## Answer by amdopt (score 2) https://quant.stackexchange.com/a/33035 > What is the risk that occurs if an investor hedges a short OTC foreign exchange forward sale with a long exchange traded foreign exchange futures with different maturities. - Counter-party risk. If the OTC counter party defaults on its obligation to deliver (this means the main leg of the trade has gone in your favor) you are left with the exchange traded part that is in a regulated account being marked-to-market with a loss. - Different maturities gives you an obvious risk. When the hedge expires you are left with you short forward contract uncovered. > And how can the residual risk be hedged? The residual risk for #1 could be hedged with a CDS that you enter into with 3rd party but then you are exposed to the risk of them defaulting on their obligation as well. It also cuts into your profit margin. For #2, just roll your futures contract to the next expiry. This will also cut into your profit margin--assuming the futures curve is in contango. Instead of having an fx forward with a hedge you may consider just reducing the size of the fx forward trade in the first place. This may not be an option for you but if it is it gets rid of the need to hedge and reduces the counter-party risk. Oftentimes an easier, less complex (and always overlooked) way to reduce exposure is to reduce the size of a base position rather than to hedge and re-hedge and re-hedge a position that is clearly uncomfortably large in size.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.