Question

A U.S. corporation is considering using currency options and currency futures contracts. Explain to this corporation the advantages and disadvantages of each contract to hedge its exposure in Mexican pesos. Which derivative contract should the corporation use to hedge projects that are anticipated but not committed?

Answer 1

The advantages of currency options are that

1) Using a small amount of options, one can hedge large exposures

2) The option premiums are smaller and thus smaller initial outlay is required

Disadvantages being:-

1) If options are not exercised, then the option premium paid is lost forever.

2) The lot of the option contracts may not exactly match the underlying exposure.

For future contact, the advantages are:-

1) The value of future contracts can match the underlying exposure

2) The contracts can be settled in an exchange and thus provides good liquidity

Disadvantage

1) The contracts have to be exercised as they need to squared off when the actual obligation matures. So not suitable for speculative investment

For project which are anticipated but not committed, it is prudent to go for option contract, since they provide option to exercise the contract without creating a mandatory obligation