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Finally, the last step is to choose whether the instruments should be of the exchange-traded or overthe-counter
variety. Forwards and swaps are over-the-counter instruments; futures are exchangetraded
instruments. Options are generally exchange-traded, but they can also be bought over the
counter. Exchange-traded instruments are standardized, and are thus liquid and entail low transaction
costs. But since they are standardized, they may not perfectly suit the risk exposure the firm wishes to
hedge. Over-the-counter instruments can be custom tailored, but they are therefore less liquid and
more expensive in terms of transaction costs. The firm must weigh the costs and benefits of liquidity,
differences in transaction costs, and custom fit. The correct choice depends on the particular hedging
situation.
A couple of examples will illustrate the process of putting all the factors together to pick the bestsuited
hedge. An American manufacturing firm owns a production facility in Canada. Rent and wages
are paid in Canadian dollars. Consequently, if the Canadian dollar rises in value, the wages and rent
translated into American dollars would become more expensive. If the Canadian dollar falls, the
expenses in terms of American dollars decline. Thus, the exposure is symmetric. If the firm wishes to
completely eliminate the exposure, a symmetric instrument is called for, ruling out options.
The firm should go long in Canadian dollar futures or forwards, since either of these instruments
will provide positive cash flows when the Canadian dollar is rising. An exchange-traded Canadian
dollar futures contract is available. The commission on the forward is greater than the commission on
the futures, but the futures contract covers slightly more Canadian dollars than the firm wishes to
hedge, and the timing does not exactly correspond to the timing of wage and rent payments. An overthe-counter
forward contract could be constructed so that cash flows are synchronized with wage and
rent payments. After weighing the two alternatives, the managers decide that the benefit from lower
commissions on the futures contract outweighs the disadvantage of the futures‟ slight mismatch in the
hedge. They go long in Canadian dollar futures.
The same manufacturing firm has many customers in Venezuela. If the Venezuelan currency (the
bolivar) falls in value, the American dollar value of the revenue will fall. If the Venezuelan currency
rises in value, the dollar revenue will rise. Thus, the risk is symmetric, and so the list of hedging
candidates is narrowed to futures and forwards. The firm benefits from a rise in the bolivar, and loses
when the bolivar falls. Thus, the firm should go short in bolivar futures or forwards, so that a cash
flow will be received if the bolivar falls. No bolivar futures contracts are available on exchanges, so
the firm must go short in over-the-counter Venezuelan bolivar forwards.
A producer of copper wire purchases large amounts of copper as a raw material. When copper
prices rise, the firm must either absorb the higher expenses or raise the price of copper wire. Raising
the price of wire, however, causes customers to cut back on purchases, causing the firm to be stuck
with unsold inventory. When copper prices fall, alternatively, competitors lower their prices, so the
firm must also lower its price in order to sell its output. Consequently, the firm‟s profits suffer when
copper prices rise, but profits do not increase when copper prices fall. Management would like to
increase production capacity, but it is difficult to forecast how much the firm can sell, given recent
copper price fluctuations. With current levels of raw copper inventory, management believes that raw
copper prices can rise as much as 10% without significantly impacting the firm‟s bottom line. What is
the appropriate hedge?
Clearly, the firm faces an asymmetric risk. The firm is hurt when copper prices rise, but does not
benefit when the price falls. An option will best mitigate the risk. Since the firm is hurt when copper
prices rise, a call option that pays off when copper prices rise is the best choice. Since the firm can