Question

Options - are contracts that give the holder the right, not obligation to buy or sell the underlining asset at a specific price and time.These can be used as hedging strategies and speculation. How and why are options used to protect holdings of corporations? Also for Investors? Provide an example along with an advantage and disadvantage along with your opinion on them.

Answer 1

As rightly said, options are contracts that give the holder the right but not the obligation to buy or sell the underlying asset at a specific price and time and are used by organizations as well as the investors for speculating as well as for hedging purpose.

The ways in which corporations use options to protect the holding companies is as follows :-

1.) Forex risk reduction - There could be a case that a holding company of a parent company might be located in a different company. In this way the profits received could be correlated with the exchange rate between the two countries. So the forex fluctuations could lead to the fluctuating profits for the parent company. To hedge this risk, the parent company may get into the respective options to buy the forex at a particular price and date from a third party like bank and hence, reducing the currency risk by paying premiums for the same.

2) Change in the prices of raw materials - There could be case when the holding company might need specific raw materials at a particular time in future like gold for producing wires but the price of the fluctuating good in the international market could affect the productivity and thus profits. Getting into options in order to hedge the raw material exposure can help to reduce the risk exposure to productivity and profits.

3.) Change in the risk free rates or interest rates- if the organization feels it would need to spin off a subsidiary in future and buy financial assets with the same. It is anticipated that the rates will fall in future so the organization can buy derivative contracts for the same in order to lock in the rates for profitability in future.

For the investors options can be used to hedge the risk as well as for speculation in the following ways :-

1.) Speculating - If the investors feel that the price of a particular stock may rise in future, he can buy call options for the same now at lower price . If the price of th stock rises in future, he can exercise the option and sell the stocks for a higher price making profits.

2. Hedging - Options can also be used for hedging purposes. Lets say there is a Jeweller who thinks the present price of his raw material which is gold is fluctuating and he will need to buy the same which he anticipates will rise in future. So he can buy call options for the same so if the price of gold rises, he can still buy the same at a lower price by exercising the option.

The advantages of options are as follows :-
1.) Leverage - Options have a very low margin requirements and thus let you trade in very large volumes with very less investment. They can magnify your returns.

2. Strategies - Options let you make distinct types of strategies to capitalise on the opportunities available in the market happening due to factors like macro economics factors.

3. Risk Reduction Instruments- If used with proper knowledge, options can serve as great risk reduction tools.

4. Regulated - Options are traded on exchanges and are insured by counterparties like Clearinghousesl thus eliminating the risk of defaults.

The disadvantages are as follows :-
1.) Risky Investments - As said in the advantages, they can magnify returns. So they can magnify returns in the negative direction too incurring losses.
2. lack of liquidity - Many options on specific stocks are not even available.

3. Complex Strategies - The strategies are usually complex and very difficult to apply.

As per my opinion, they are amazing instruments for hedging as well as speculating if used with proper knowledge and caution.
Ofcourse, they are risky and can lead to disasterous effects like we have all seen in the financial crisis of 2008.

I hope this helps you.
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Thanks & Regards.