Question

The advantage if the option hedge is used to hedge the firm’s foreign exchange rate.

Answer 1

There are various type of hedging tools available to hedge foreign exposure.

They are:

1. Forward Contracts

2. Future Contracts

3. Options - Put & Call.

When an organization use option hedging, it gives advantage to that firm to save itself from any loss due to change in foreign exchange and take advantage of any favourable change.

The above advantage is not available in forward contracts or futures contract. Such hedging only saves an organization in unfavorable foreign exchange rates. These hedging tools does not let organization to enjoy the favourable change.

For example, if a company in India has USD 500,000 receivable after 1 month and it enters into a forward contract to sell USD at Rupees 70 per USD. After 1 month 1 USD = Rupees 75.

Therefore, the company is in a loss of Rupees 5 per dollar.

On the other hand, if the above company had bought a put option to sell USD at Rupees 70 it would have given company the right to save itself from decrease in USD rate. However, if after 1 month USD = Rupees 75 then the put option will lapse and the company can sell at USD at Rupees 75.

Hence, from the above example it is clear that option hedging helps an organization to take benefit of the favourable change in foreign exchange rates and saves it from unfavorable change. However, forward and futures contract only saves from unfavorable changes in foreign exchange rates. This is the advantage of option hedging.

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