Question

What are the advantages and disadvantages of using options contracts relative to forward contracts to hedge against transaction exposure? Which contract would you use for committed transactions? How about for anticipated transaction? Explain your answer.

Answer 1

Advantages of using options relative to forwards is that we have the right but not the obligation to act on the contract. Hence, if the price goes against us, our downside is limited in options which is not so in futures. Also, there is no margin requirement in options which is there in futures and forwards.

Disadvantage of using options over futures is that an upfront payment (option premium) has to be paid which is not to be paid in forwards and futures.

For committed transactions, we would use futures because we know that the transaction would be processed, so we can lock in our gains through futures (though options can also be used if we are willing to pay the upfront premium)

For anticipated transactions, it makes no sense to use futures as it is a commitment and if the transaction does not occur, we would be left with the futures position. Hence, for anticipated transactions, we should always use options.