Hedging strategy is typically misunderstood by all but the most knowledgeable insiders. Futures, forwards, options and swaps are the most commonly employed money market hedges. Further, financial engineering and large investors continue to roll out "exotic" products that add to the confusion. Institutions often have difficulty simply selecting the right product for the right situation.
Hedges are typically related to derivatives, which derive their valuations from other assets. This added layer of valuation that must be adjusted according to the overall mechanics of the particular hedge makes the pricing of these strategies prone to wild fluctuations. Volatility increases further as the contract approaches its execution date. At the extreme end, investors realize the fact that unexercised options expire worthless.
Disclosure, or its lack thereof, is always an issue with derivatives. Obviously, derivatives can be traded frequently and financial managers often do not know who holds what. Contracts carry counterparties that must make good on the agreement to deliver assets at a specified date. When investors believe that a particular institution is weak, they begin to liquidate haphazardly. This is because the impact of failure is often unknown.
Because of the volatility, businesses and the accounting industry disagree on how to present hedge positions upon financial statements. Marking to market may show losses, even when the business has no intention of selling the contract at a loss. Shareholders may need detailed knowledge of accounting practices to sort through the presentation of derivatives within annual reports.
Disclosure practices are further muddled by the idea that large investors are not likely to openly telegraph each transaction. Markets are highly competitive, and access to institutional trading patterns reduces their chances for profitability.
The basic foreign exchange hedges are inflexible in some way. Futures that trade upon organized markets are liquid, but do not allow for customization. Forward contracts are customized between two parties, but are not liquid. Futures and forwards carry legal obligations for investors to deliver and accept payment or assets at a set price and date.
Options are exercised at the discretion of the holder. Again, unexercised options expire as worthless instruments.
Real and Opportunity Costs
Investors must remit payments to buy derivatives and put together hedging strategies. For example, payments to purchase options are referred to as premiums. These payments become losses when the options are not exercised.
Opportunity costs relate to foregoing profits from another transaction. Opportunity costs are more so associated with futures and forwards contracts that enforce execution. You may not be able to participate within favorable developments related to a particular asset because a rate of exchange has already been agreed upon.