Question

Options contracts are an alternative to futures and forwards contracts to hedge FX risk. Why would investors prefer to use options rather than futures or forwards? Under which future outcomes do options provide an advantage relative to forwards or futures contracts? Why might managers choose not to enter into options contracts?

Answer 1

Option contracts are preferred by investors rather than future contracts or forward contracts because of following reasons-

A. Option contracts are providing with the right not an obligation to exercise the contract, so there will be a very high degree of flexibility which is embedded into the option contract.

B. Option contracts are also cheaper in comparison to the future and forward contract.

C. Option contract will not be having any individual transaction risk like in forward contract and they will be continuously trading on stock exchanges and they are highly transparent.

Option contracts will be providing with advantage when there will be a very high degree of volatility and investors are trying to capture large movement by incurring very small price so they will be trying to either buy out of the money call option or out of the money put option.

Manager will be choosing not to enter the option contracts and they will feel that there will not be much volatility and these contracts will be leading to loss of the cost and there will be overall loss due to time decay of these options as there will not be any volatility and there will not be any movement so these options are going to become worthless in coming time so managers will not be entering into those options when there would be a low volatility or they will also not buying into the out of the call or out of the money put option because they will feel that there is not a environment of high volatility.