Question

Discuss the differences in using an option to hedge a foreign currency risk rather than a forward contract.

Answer 1

Hedge:- We have purchased a share and we are thinking that the price may fall and we can have loss. Hence to cover the loss we can purchase options like in this case, we can purchase put option since we are thinking that price will decrease. This is called hedging since if the price will fall, we will be incurring loss in share purchased but we will cover some loss by purchased put option. In case we have sold the shares and we are thinking that the price may increase, we can buy call option.

Forward Contract:- We need to invest say $3M after 3 months and now the dollar rate is $60. We have a fear that the dollar rate may increase and we may have to pay more. Hence to cover the loss, we can purchase a forward contract from qualified institutional buyers containing $3M at $61 now. Now, we will pay at $61 only whatever the price may be after 3 months when we will invest since we have purchased forward contract.