Question

1. What does the term hedging mean? Why do companies elect to follow this strategy?
2. Why would a company prefer a foreign currency option over a forward contract in hedging a foreign currency firm commitment? Why would a company prefer a forward contract over an option in hedging a foreign currency asset or liability?

Answer 1

A. Hedging is referred to as buying an asset designed to reduce the risk of losses from another assets. Hedging in finance is a risk management strategy that deals with reducing and eliminating the risk of uncertainties. It helps to restrict losses that may arise due to unknown fluctuations in the price of the investment.

B. Hedging is an important part of doing business. When investing in a company you expose your money to risks of fluctuations in many financial prices - foreign exchange rates, interest rates, commodity prices (oil and so on) and equity prices. If a company makes sweet treats, the price of sugar is going to be watched closely. If a business relies on a fleet of lorries to move goods, then the price of petrol is key. More often than not, though, in today's global business world, the killer movers are currencies. The impact of changes to market prices can have a devastating effect on profits, so companies will seek to shield the sensitivities of their core business.

C. Main reoson why a company may prefer option contract over forward contract in hedging is following:

C1. Foreign currency options have an advantage over forward contracts in that the holder of the option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain).

C2. The company will choose a foreign currency option over a forward contract in hedging a foreign currency firm commitment because the dispatch date and cost is determined by the commitment of the firm. The currency option gives the advantage to the company of not paying in case of damaged goods or fluctuating prices.

D. Main reoson why a company may prefer forward contract over option in hedging is following:

D1. If price moves are favorable, the producer realizes the greatest return with this marketing alternative in a forward contract.

D2. No premium charge is associated with forward market contracts.