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?
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.