Question

Discuss how financial options are used by corporate financiers or investors to hedge risk or reduce the riskiness / improve the results of their investment strategies / portfolios. You should use examples to illustrate your arguments.

Answer 1

Corporation uses options and forward contrat to hedge the risk of it's payable and receivable.

When corporation has receivable in foreign currency it faces risk that the foreign currence might depreciate or home currence might appreciate. If this happens than the corporation would get less units of home currency against units of foreign currency. To mitigate this risk one can sell forward contrat on foreign currency or buy forward contact on home currency. Alternately one can buy put option on foreign currency or buy call option on home currency.

For example if corporation has receivable in $ and is based out of india. Currect spot rate is 1$ = 60 Rs, now if corporation do not hedge it risk and exchange rate changes to 1$ = 55 Rs , then corporation will incur loss

In same way if corporation has payable in foreign currency then it faces risk that the foreign currence might appreciate or home currence might depreciate. If this happens than the corporation would have to pay more units of home currency against units of foreign currency. To mitigate this risk one can buy forward contrat on foreign currency or sell forward contact on home currency. Alternately one can buy call option on foreign currency or buy put option on home currency.

For example if corporation has payable in $ and is based out of india. Currect spot rate is 1$ = 60 Rs, now if corporation do not hedge it risk and exchange rate changes to 1$ = 65 Rs , then corporation will incur loss