Question

Suppose that an US airline receives a considerable portion of its revenues in euros, and is concerned about exchange rate risk. Two hedging choices the firm is considering are (i) futures contracts on the euro and (ii) call or put options on the euro.

Explain whether this firm should buy or sell futures contracts on the euro. Alternatively, the firm could hedge using options. In that case, should the firm use call or put options and should the firm buy or sell these options?

Discuss the advantages and disadvantages of hedging using options as compared to futures contracts.

Answer 1

Since the US airline receives a considerable amount of its revenue in Euros, it is always a better option for the company to hedge its position, so that risk can be mitigated to the lowest possible. Before suggesting a future or option strategy to the company, it is better to understand the advantages and disadvantages of using options instead of futures. These are discussed as follows:

Advantages

• The downside risk in options are limited
• The buyer knows about the maximum cost, because he has to make payment of both premium and brokerage cost at the time of initializing the trade.
• No margin is required.
• Due to its low risk nature, the volume is usually very high in options as compared to futures making it more liquid than futures.

Disadvantages

• The premium that is being paid by the buyer, may change significantly based in the situation of market. This is not the case with margin requirement of futures.
• In futures, there is no time decay that will take place as compared to options, whose premium gets decayed as the expiry of the contract reaches close.
• The pricing is easier to understand unlike options premiums which are difficult to understand and changes rapidly.

The company have to sell future contracts of Euro. US airline is a US company and thus do not need Euros, it will have to sell Euro future to lock in a rate now for the Euros that they will receive in future. In the process, if Euro depreciates the company will make gain on its receipts of Euros, however, if the Euro appreciates then the company may incur loss on its position.

Alternatively, the company can buy put option of Euro by paying a premium and in case Euro depreciates, the company will be facing loss on its Euro receipts, which can be covered by the gain that will made through purchasing the put option.