Which is the most commonly used method of hedging?

Forward exchange contract is the most used method for hedging.

• In case of exchanges, if the company is going to receive a large sum of foreign currency from customers it bears the risk that the currency will depreciate and the company will go short in a currency forward contract. If the company is going to pay its suppliers, it instead will go long.
• Foreign exchange swaps are a common type of money market instrument, involving the exchange of a set of currencies in spot date and the reversal of the exchange at a predetermined time in the future. Their commonest use is for institutions to fund their foreign exchange balances.
• Futures are very similar to forwards, except they are exchange-traded, or defined on standardized assets. Futures also typically have interim partial settlements, or "true-ups," in margin requirements.

• margin

   

  Collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty.

   

• spot exchange rate

   

  the agreed upon price of buying one currency in terms of another now

   

• forward exchange rate

   

  the agreed upon price to exchange one currency for another at a future date

   

• underlying assets

   

  In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the (former) derivative depend on the value of this underlying.

In finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today. The party agreeing to buy the underlying assets in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. In the case of exchanges, when entering a forward contract the buyer hopes or expects that a currency is going to appreciate, while the seller hopes or expects that it will depreciate in near future. If the company is going to receive a large sum of foreign currency from customers as payment, it bears the risk that the currency will depreciate and the company will go "short" in a currency forward contract. If the company is going to pay its suppliers with foreign currency, it will instead go "long. "

As money became a commodity, the money market became a component of the financial markets for assets involved in short-term borrowing, lending, buying, and selling, with original maturities of one year or less. Foreign exchange of currencies are among the more common money market instruments, exchanging a set of currencies in a spot date and the reversal of the exchange of currencies at a predetermined time in the future. The most common use of foreign exchange swaps occurs when institutions fund their foreign exchange balances. A foreign exchange swap consists of two legs: a spot foreign exchange transaction and a forward foreign exchange transaction.These two legs are executed simultaneously for the same quantity, and therefore offset each other. Once a foreign exchange transaction settles, the holder is left with a positive (or long) position in one currency, and a negative (or short) position in another. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day. To do this they typically use tom-next swaps, buying (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) it back and settling the day after.

In finance, a futures contract (more colloquially, futures) is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and payment occurring at a specified future delivery date. In many cases, the underlying asset to a futures contract may not be traditional commodities at all – that is, for financial futures the underlying item can be any financial instrument (including currency, bonds, and stocks). The party agreeing to buy the underlying asset in the future, the buyer of the contract, is said to be long, and the party agreeing to sell the asset in the future, the seller of the contract, is said to be short. The same mechanism functioning in forward contracts applies to futures.

Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures – such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open.

Forward Contracts and futures are the most common. They differ as forwards are non standardized and can can have a perfect hedge, while futures are standardized but have a specified contract size.

Forward Exchange Contract is the common instrument

The use of a derivative instrument will be the current most common method used. The type of instrument (forward contract, option, future etc) will be determined by the reason and the instrument involved you want to hedge, ie commodity, forex, interest rates or even other derivative instruments.

Here are five essential hedging techniques that you'll learn about in this installment of "The Finance Professor":

• Pairing
• Short against the box
• Exchange-traded funds (ETFs)
• Futures
• Options