Discuss the hedging options: forward contracts and option contracts
Discuss the hedging options: forward contracts and option contracts. There are some risks involved with international transactions due to fluctuations of the foreign currency exchange rates. One way to mitigate those risks is through hedging. A forward contract is like a futures contract where one trader specifically agrees with another trader or entity to enter into a contract to buy or sell a foreign exchange. This form of hedging operates on the future value of the foreign exchange and a certain term and maturity length based on the days that the exchange is desired to take place. An options contract is just like the name suggests. It is indeed a contract that two
traders or entities enter into, but it is designed to give the buyer or seller simply the option to enter into a further agreement to buy or sell foreign exchange. The goal is to set parameters for the trade; there is a time window and/or a price window for which the trade will be valid. Otherwise, the traders can choose not to exercise that “option” if the price never falls within the desired window during the given timeframe.
What are the advantages and disadvantages of each alternative? What are the costs of each alternative? When is one alternative preferred over the other alternative? A forward contract can be disadvantageous to an options contract because the given trade is set for a predetermined date and price whereas an options contract has ranges where the trade could or could not take place. Both will likely come with brokerage fees, which is to be expected. However, if a trader pays the fees for the options and they never use them, it would have been a waste of money. This is the nature of hedging. One alternative is preferred over the other when the trader is able to
comfortably and accurately speculate the likelihood of the trade being in their favor or not. If they are simply totally unsure but willing to purchase options and risk that small amount of money, they would prefer the options contract. It likely depends how much information they do or do not have, on a case by case basis.
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