Abstract
Equity investors tend to hedge using futures, which presents both the highest level of risk (defined as distribution of returns for equities) and the highest level of protection against counterparty risk in the hedge instrument. When hedging interest rate risk, swaps are usually used. Swaps offer the next best level of counterparty protection for what is the lowest level of risk. The forward market is left with an ordinal mismatch between the level of risk in the market it is intended to hedge—the FX market—and the level of protection that is inherent in the swap or futures market. A solution exists, however, to put forward contracts in the proper risk management structure: collateralization. By posting zero-threshold daily-mark-to-market collateral requirements with forward counterparties, the risk of a loss in the event of a default on a forward agreement is more credibly contained.
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