Currency Options & Futures: Key Differences & Advantages

Currency Options & Futures: Key Differences & Advantages

13 Aug 2019 04:17 PM
 

What is currency hedging?

The paramount importance of currency hedging is deeply rooted in the forex market's volatility, which exposes its participants to currency risk.  For an organization with operations worldwide, the necessity for hedging against forex risk is manifold since it deals with foreign currencies on a large scale, where any fluctuation in forex rates ultimately affects the revenue, profits and cash flow availability for operational efficiency of the organization. While some companies believe in employing extensive hedging strategies, others might not find its relevance in their operations, maybe because of scale or cost-efficiency. 

A forex hedge is a transaction that fortifies an individual or corporation from an unwanted move in exchange rates owing to the market volatility and protects the existing or anticipated position of forex market participants. Forex hedge implementation is observed in businesses, investors, and traders. Currency Hedging is the move of entering a financial contract to protect against expected, unexpected, or anticipated changes in currency exchange rates. Financial investors and businesses undertake currency hedging to eliminate risks faced by them when exercising business internationally. Hedging can be a very entangled enterprise. The various hedging mechanisms range from basic to incredibly intricate. When considering a hedging strategy, the most sagacious first steps would be to take note of foreign exchange exposure and, based on that, comprehend what goals need to be set and what measures need to be taken to mitigate that risk.

Currency futures, and foreign currency options are the widely used currency hedging methods bearing features like locking an exchange rate now for a delivery time in the future. Entering a currency futures contract doesn’t command an upfront cost making them a lucrative currency hedging vehicle. Although, a foreign currency option, because of its non-obligatory nature, is one of the most popular currency hedging methods. 

What is the Difference between Currency Options & Currency Futures?

The point of difference between options and futures is reflected in the terms that they extend regarding buying and selling a particular currency. They are both used as hedging instruments which are better suited for different situations due to the distinctive contract structures and risks associated with them. Currency futures are obligatory contracts traded on a centralised exchange which enable buying or selling a certain currency at a predetermined price on a specified future date. In contrast, Options are non-obligatory that gives an individual the right but not the obligation of buying or selling a particular asset at a specific price on a specified date. Another differentiating factor is the risks an individual incurs with futures and options. Options are risky owing to their complex nature wherein one can go long with fixed risk and unlimited return or go short with fixed return and unlimited risk. The gains on futures positions are automatically marked to market daily, influencing the money to be deposited by both the parties of an agreement into their trading accounts, futures carry larger risks for the individual investor.

How does currency options work?

A currency option also known as a forex option is a contract that provides the buyer with the right, but not the obligation, to buy or sell a particular currency at a given exchange rate on or before a determined date. They are a derivative form of investment where the actual ownership of underlying assets is not represented until agreement finalization. A premium is paid by the buyer to the seller for options contracts, representing the strike price which is the rate to buy or sell the asset till the contract's expiration date. The elements of options in decentralized forex markets vary considerably more broadly than the options in the more centralized exchanges of stock & futures markets. Call options and put options are the only two types of option where a call option is an offer to buy a stock at the strike price prior to the agreement expiration, and a put option offers selling a stock at a specific price. Investors can enhance their security against foreign currency risk by the purchase of a currency put or call. Trading currency options include a wide variety of strategies which are available for use in forex markets. 

How does currency Future work?

Currency futures are the standardized contracts that are traded on centralized exchanges. The Futures are either done on cash settlement or physically delivered. Cash-settled futures are settled daily on a mark-to-market basis. As and when the daily price changes, the differences are settled in cash until the expiration date. For futures that are settled by physical delivery, the currencies have to be exchanged for the amount indicated by the respective size of a contract at the expiration date. Foreign exchange futures contracts have many components which are outlined below:

  1. The Underlying Asset is the specified currency exchange rate. 
  2. The expiration date for physically delivered futures is the day the currencies are exchanged. 
  3. Contract sizes need to be standardized. For example, a euro currency contract is standardized to 1,000 Euros in India.
  4. Margin Requirements are an inevitable component to enter into a futures contract. A maintenance margin also needs to be established, and if the initial margin falls below this very point, a margin call will happen to state that the trader or investor must deposit the money to bring it above the maintenance margin.

Advantages of using Currency Options over Futures

Cost Efficiency - A great leveraging power is displayed by options wherein an investor incurs huge cost savings while obtaining an option position similar to a stock position.

Reduced Risk- While buying options can be riskier than owning the foreign currency in a certain situation; it can also be utilized to reduce risks depending on how one uses them. Since they require less financial commitment compared to buying foreign currency, options can prove less risky for investors and are considered a more dependable form of a hedge, making it safer than being unhedged. 

Potential Returns- The biggest advantages that options carry are the higher percentage return they provide to the investor as you make almost the same profits while spending less money. 

Strategic Alternatives-  Options are a very flexible tool and can recreate other positions providing more investment alternatives necessary for profit in every market. Synthetic positions are one of the strategic alternatives that options offer, presenting multiple ways for investors to reach the same investment goal. One crucial benefit of options is that it offers the investor to trade not only currency movements but also the passage of time and movements in volatility which could be the deciding factor in reaching your financial goals since you are taking advantage of stagnation in the market which persists predominantly rather than larger currency movements. 

Both futures and options, if used strategically, can be used for deriving profits and enhancing your security against forex exposures. Myforexeye helps businesses and individuals with the Forex Risk Management strategy that extends customized solutions based on quality research of the market happenings and trends. Our risk-mitigating strategies cater to the problem you have at hand that needs to be resolved wherein our consultants explain our detailed reports and analysis. Besides the risk mitigation service that focuses on protecting your business's budgets, we also provide you access to live forex rates to corroborate your forex decisions. 

Conclusion

MyForexEye is committed to providing a resolution to your Forex and trade finance needs and filling the gap of the unmet demands in terms of credit and financial guidance to MSMEs and larger corporates. Through our team of experienced professionals and consultants well versed in the field of trade finance, we dispense streamlined processes for one's convenience and at one's disposal. The force at play, corroborating our efforts of providing solutions that are effective to companies for realizing their maximum potential, are the latest technology and assistance from the veterans of the trade finance industry. Our objective is to aid our clients in making savings and eliminating the aspect of hidden commission fees payable to the bank. Our user-friendly digital platforms- web portal and mobile app, renders one capable of accessing instant quotes and calculating interest costs.

Speak to one of our specialists to acquire a detailed understanding of forex services offered by Myforexeye. 

Disclaimer- The website is to provide information only.

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