Currency hedging is an integral part of Forex Exchange and Risk Management. It is basically implemented to avoid risks while conducting business internationally. In order to hedge risks, popular currency hedging tools such as options and futures are used in order to mitigate the underlying risks.
Although, options and futures may sound somewhat similar but the fact is, they are fundamentally different from each other. So, let’s understand the difference one by one.
The fundamental differences between option and future is that-
On the other hand, in the case of future, buyer purchases shares and seller sells them on a specific future date until the holder’s position is closed before the date of expiry.
While in the case of options, it is done in two levels- Call options and put options. In the case of call options, buyer gets the right to buy or sell underlying stock or index at preset price during the contract’s liquid life- say a month or may be weeks. While in the case of put options, buyer sells share at preset price during contract’s life.
Detailed Explanation of Currency Options
Options give an investor the right and no obligation to buy or sell shares at a specific price at any time, as long as the contract is in effect. Corporations, individuals or financial institutions use options commonly to hedge against adverse movements in exchange rates.
They are mainly of two types- Call Options and Put Options. Both of them are contracts known as derivatives because they derive their values from other securities, contracts and assets. Both call and put offer a flexible way to hedge the investments. One of the interesting fact on put and call option is that, they offer a flexible way to hedge investments. Options are used to speculate on investment ideas at a relatively low cost.
A call is an options contract which gives the buyer the right to buy the underlying asset at the strike price at any time up to the expiration date. Stock call option with a strike price of 10 implies the option buyer can use the option to buy that stock at $10 before the option expires.
A put on the other hand is an options contract which gives the buyer the right to sell the underlying asset at the strike price at any time up to the expiration date. Stock put option with a strike price of 10 means the put option buyer can use the option to sell that stock at $10 before the option expires.
For example in the case of currency options strategy for import transactions, say on 2017, ABC purchases a USD call option that covers import transactions at a strike rate of 45.50. The expiry date is three months here (31st October, 2017) and the premium amount is set at 30 paisa on the call. Gain or loss on expiry at various levels of exchange rate is mentioned below-
Key Observations from the Above Example
You must have witnessed that when spot exchange rate rises above the strike price, there is significant gain but when it is the contrary, ABC witnesses’ losses which are maximum to the level of premium paid.
Likewise, let’s take an example of currency options strategy for export transaction to understand how it works. Say, ABC purchases USD put options on 1’st August 2017 that covers its export transactions at a strike rate of 45.50. Here too the expiry date is 3 months (31st August 2017) and the client pays a premium of 30 paisa on the put. Check what gain/loss the client witnesses at various levels below-
Key Observations from the Above Example
You must have witnessed, when the spot rate falls from the strike rate, ABC witnesses gains while here when the spot rate increases from the strike rate, the party witnesses a losses that are maximum to the level of the premium paid.
Option Contracts: Important Feature
Detailed explanation of Future contracts
Future contracts are one of the most common derivatives used to hedge risk. This kind of contract is basically an arrangement that is made between two parties to buy or sell an asset at a particular time in the future for a certain price.
Future contracts can be useful in limiting the risk exposure that an investor has in a trade. In fact the main advantage of participating in a future contract is to remove the uncertainty about the future price of an item. By locking in a price for which one is able to buy or sell a particular item.
Future Contract: Important Features
Advantages of Using Currency Options over Future
The features of options contract are appealing and perhaps this is the predominant reason why this hedging tool is more commonly used over futures contract. Currency options are generally practiced in two styles- the European and the American style of options contract. In India, generally the “S&P BSE SENSEX” is practiced in the European style so the exercise date is the same as that of the expiration date. While in the case of options used on individual are generally stocks in the American Style. So here, the option contract is exercised any day between the purchase of the contract and its expiry date.
Let’s dive in to understand the some of the advantages of options contract over Future contract-
Thus, you must have by now understood that although both future and options are trading products which helps importers and exporters to make money taking all the precautionary measures to hedge risks associated with current investments, they aren’t same tool. So we recommend you to make use of this tool and derive its benefits to the utmost level by consulting with a forex advisor. Myforexeye helps businesses with Forex Risk Management strategy. This can help your business manage forex exposure and assets in gainful ways.
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