Compare and contrast foreign currency futures and options. Identify situations where you may choose one or the other.
When Barings Bank, the oldest merchant bank in London, collapsed in 1995 after one of the bank’s employees lost £827 million due to speculative investing, primarily in futures contracts, it illustrated the extreme danger and volatility of derivatives. Options and futures can be used to eliminate, reduce, hedge and manage risk, but can also be highly speculative.
Foreign currency futures are standardized contracts to buy or sell a specified commodity of standardized quantity at a certain date in the future and at a market-determined price.
Foreign currency options are contracts that give the option purchaser the right, but not the obligation, to buy/sell a specific amount of currency at a specified price, on or before the maturity date, and it also gives the option purchaser the right to decide later whether to buy/sell/exercise the option. There are two types of options: the call option, and the put option.
Call Option – give the purchaser a right to buy foreign currency Put Option - gives the purchaser the right to sell foreign currency
1. Both are derivative securities for future delivery/receipt. Agree on price and quantity today for future settlement or delivery in 1 week to 10 years. 2. Both are used to hedge currency risk, interest rate risk or commodity price risk. 3. In principal they are very similar, used to accomplish the same goal of risk management.
The main fundamental difference between options and futures lies in the obligations they put on their buyers and sellers. An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at any time during the life of the contract. A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date, unless the holder's position is closed prior to expiration.
Aside from commissions, an investor can enter into a futures contract with no upfront cost whereas buying an option requires the payment of a premium. Compared to the absence of upfront costs of futures, the option premium can be seen as the fee paid for the privilege of not being obligated to buy the underlying in the event of an adverse shift in prices. The premium is the maximum that a purchaser of an option can lose.
The final major difference between these two financial instruments is the way the gains are received by the parties. The gain on an option can be realized in the following three ways: exercising the option when it is deep in the money, going to the market and taking the opposite position, or waiting until expiry and collecting the difference between the asset price and the strike price. In contrast, gains on futures positions are automatically 'marked to market' daily, meaning the change in the value of the positions is attributed to the futures accounts of the parties at the end of every trading day - but a futures contract holder can realize gains also by going to the market and taking the opposite position.
Situation to use FUTURES CONTRACT:
Investors use futures contracts to hedge against foreign exchange risk. If an investor expects receipt of a cash-flow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cash-flow.
For example, an investor who will receive €1,000,000 on December 1, can lock in at the current exchange rate implied by the futures at $1.2/€ by selling €1,000,000 worth of futures contracts expiring on December 1. That way, she is guaranteed an exchange rate of $1.2/€ regardless of exchange rate fluctuations in the meantime.
Situation to use OPTIONS:
Corporations primarily use FX options to hedge uncertain future cash flows in a...
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