Question

Assume you are the manager of a financial institution. You are considering some strategies for hedging interest-rate risk. Would you prefer using futures or option contracts? Why?

Answer 1

Futures and options are both derivative instruments as both of them derive their value from an underlying asset or instrument. The most loved advantage of options is obvious. An option contract provides the buyer with the right, but not the obligation, to buy or sell an asset or financial instrument at a fixed price on or before a predetermined future date which limits the risk to the buyer of an option to the extent of premium money paid.

Futures are best suited to commodity investor or someone involved in currency exchanges.  A futures contract is a legally binding agreement between a buyer and seller to buy or sell an asset or financial instrument at a fixed price at a predetermined future date. Some advantages of futures over options are:

1. They are standardized set of contracts and offer a high leverage which makes them suitable for the risk tolerant class of investors. The option investors belong to risk avoidance class.
2. The margin requirements remains unchanged over the years changing only temporarily and that too on rare occasions. Thus traders have an idea of how much to deposit as initial margin beforehand. Options lack this feature. The premium amount keeps changing depending on the volatility of underlying asset. The more volatile asset, the higher is the premium charged.
3. Futures provide more liquidity than options to investors

Considering the factors above, the manager should go with futures for hedging interest rate risk