Question

Differentiate between a foreign currency option and a foreign currency forward contract. Suggest to management which one should be used in a foreign currency transaction.

Answer 1

Differentiate between a foreign currency option and a foreign currency forward contract. Suggest to management which one should be used in a foreign currency transaction.

foreign currency option:A foreign currency option gives its owner the right, but not the obligation, to buy or sell currency at a certain price (known as the strike price), either on or before a specific date.

foreign currency forward contract.: A foreign currency forward contract is an agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date.

There are major differences between a foreign currency option and a foreign currency forward contract. These are tabulated below:

foreign currency option	foreign currency forward contract
A foreign currency option is a derivative contract giving the holder (buyer) the right, without the obligation, to trade (buy or sell) a specific currency at or by a specific date.	a foreign currency forward contract is a derivative contract an agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date.
An option contract entails that the buyer pays the writer (seller) an upfront premium.	In a forward contract, no upfront payment has to be made.
losses to the buyer are limited to the strike price	losses to the seller may be unlimited depending on how far market prices would go beyond the strike price
In terms of obligation, the buyer of an option has the right but not the obligation to enter into a contract. The option writer (seller) is obligated to transact if requested by the buyer to do so	Both parties to a forward contract are obligated to perform the contract.

In business point of view it is better to go with currency option as the loss is restricted and there is unlimited gain potential for the option buyer. Moreover, Option contract giving you the clear advantage of making a choice on the maturity date. But if there is a confidence of the rate not going significantly lower, a Forward contract is a much cheaper alternative to hedge your rate as option contract involves upfront payment.