Currency Options & Futures: Key Differences & Advantages

Currency Options & Futures: Key Differences & Advantages

13 Aug 2019 04:17 PM
 

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.

Option V/s Futures

The fundamental differences between option and future is that-

  1. In an options contract, investors get the right but not the obligation to both buy and sell shares at any time as long as contract is in effect.

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.

  1. In the case of future contract, the stock is bought or sold at the preset price for delivery on a future date.

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-

  1. When the market rate is 44.50 and exercise rate (call @45.50) the premium paid by ABC is 0.30 and here the gain/loss is -0.30.
  2. When the market rate is 45.00, exercise rate Paid by ABC is nil ([email protected] 45.50) the premium paid by ABC is 0.30 and here the loss is -0.30
  3. When the market rate is 45.50, exercise rate paid by ABC is nil ([email protected] 45.50) the premium paid by ABC is 0.30 and here the loss is -0.30
  4. When the market rate is 46.00, exercise rate paid by ABC is 0.50 (call @ 45.50) the premium paid by ABC is 0.30 and here the loss is 0.20
  5. Similarly, when the market rate is 46.50, exercise rate paid by ABC is 1.00 ([email protected] 45.50) the premium paid by the party is 0.30 and the gain is 0.70
  6. Also if market rate is 47.00, exercise rate paid by ABC is 1.50 ([email protected] 45.50) the premium rate paid remains the same 0.30 and here the gain is 1.20

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-

  1. When market rate is 44.00, ABC pays an exercise rate 1.50 (put @ 45.50) the premium rate paid is 0.30 and witnesses a gain of 1.20.
  2. When market rate is 44.50, ABC pays an exercise rate 1.00 ([email protected] 45.50) the premium rate paid is 0.30 and witnesses a gain of 0.70.
  3. When market rate is 45.00, ABC pays exercise rate 0.50 (put @ 45.50) the premium rate paid is 0.30 and witnesses a gain of 0.20.
  4. When market rate is 45.50, ABC does not have to pay any exercise rate here (put @ 45.50) the premium rate paid here is 0.30 and the loss witnessed here is -0.30
  5. When the premium rate is 46.00, ABC does not have to pay any exercise rate here (put @ 45.50) the premium rate paid here is 0.30 and here the loss is -0.30
  6. When the market rate is 46.50, ABC again does not have to pay any exercise rate (put @ 45.50) the premium rate paid here is 0.30 and the loss witnessed here is -0.30.

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

  1. Option purchasers hold a long position and option sellers hold a short position.
  2. Options trade on public exchanges where a clearinghouse mediates all trades between buyers and sellers.
  3. Options specify a specific asset price, called the strike price from which one can measure the option’s value.
  4. Options also have an expiration date when the contracts expire. One can buy options which expire in periods ranging from a few minutes to more than a year. Options have standard weekly and monthly expirations.
  5. Options give the purchasers the right and the obligation to buy or sell a fixed quantity of the underlying asset.
  6. Option traders pay a dynamic price, called a premium to buy options.
  7. One can close an option position at any time until expiration. They can close out an option by selling the options one has bought or buying back the options you wrote at the current market price of the option.

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

  1. This type of contract is standardized contract both in terms of quantity and quality and future delivery date.
  2. Future contract is a margining process which helps in differentiating margins from exchange to exchange and may change as the exchange’s perception of risk changes. It is also known as the initial margin and in addition to it, there is also the daily variation margin and this process is known as marking to market.
  3. Majority of users are large corporations and financial institutions working either as traders or hedgers.
  4. In the future market there is availability of clearing house for settlement of transactions so future contract are exchange traded.

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-

  1. Traders who have bought an options contract will find the risks limited to the amount of the premium they pay for a contract. Further, the cost of an option is usually a small percentage of the value of the entire underlying asset. In case, option contract expires, traders lose only the cost paid to purchase the contract.
  2. On the other hand, future contract can result in losses that exceed the original margin deposits or investment. In case future trade goes in the wrong direction, traders face huge losses and this continues to mount until the traders finally decides to close out the position.

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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