A Comparison of the Effectiveness of Currency Futures and Currency Options in the Context of Foreign Exchange Risk Management

Topics: Foreign exchange market, Futures contract, Exchange rate Pages: 24 (6978 words) Published: September 26, 2011

1.1. Research Background
Exposure risk managers can hedge exchange rate risk with either currency futures or currency options. It is generally suggested that hedgers should choose a hedge instrument that matches the risk profile of the underlying currency position as closely as possible. This advice, however, ignores the possibility that the hedging effectiveness may differ for the alternate risk management tools. This study compares the effectiveness of currency futures and currency options as hedging instruments for covered and uncovered currency positions. Based on Ederington's (March 1979) portfolio theory of hedging, the results show that currency futures provide the more effective covered hedge, while currency options are more effective for an uncovered hedge. Hence, exposure risk managers do not have to sacrifice hedging effectiveness to obtain the desired risk profile.

Corporations engaged in international business transactions are commonly exposed to exchange rate risk. Since management is concerned with currency exposure, it can hedge the anticipated exchange rate risk either with futures or options. The choice of the appropriate hedging tool is generally influenced by the type of currency exposure, the size of the firm, the industry effect, the risk preference of the manager or the firm and his/her familiarity with the available financial instruments and techniques. It is also suggested that a hedger should choose a hedge instrument that matches the risk profile of the underlying currency position as closely as possible. Hence, futures contracts are more suitable for covered hedges, while option contracts are best used for uncovered hedges.

Hedging effectiveness of these two hedge instruments must be considered as well in order to evaluate the cost of obtaining the desired risk profile. Some empirical research has shown that the futures contract provides both an appropriate risk profile and a more effective hedge than an options contract for covered positions (Chang and Shanker, 1986). If these findings also hold for uncovered currency positions, then the hedging decision involves a trade-off between the desired risk profile and hedging effectiveness. That is, a hedger would have to decide whether the extra risk protection afforded by the attractive risk profile of options is worth the loss in hedging performance.

This study compares the hedging effectiveness of currency futures and currency options for both covered and uncovered positions. Ederington's (March 1979) risk-minimizing approach is applied to estimate the hedging effectiveness and the least risk hedge ratios, which in turn, are used to assess the trade-off between risk profile and hedging performance.

Multinational corporations exposed to exchange rate risk can use either currency futures or currency options to reduce or eliminate this risk. In selecting the most appropriate instrument, the risk profile of the asset to be hedged must match that of the hedging vehicle as closely as possible. According to this criterion, Moriarty, Phillips, and Tosini (January-February, 1981) observed that options are typically preferred when hedging contingent transactions, while futures are preferred for other types of transactions. The asymmetric risk protection offered by currency options gives these securities a special appeal for hedging currency transactions that are possible but not certain to occur. For example, submitting a competitive bid, or waiting on management's decision to take advantage of an opportunity to acquire a foreign asset, or anticipating the potential receipt of an award resulting from a lawsuit in a foreign court, will leave the firm partially exposed to foreign exchange rate risk. If, in this case, the transaction does not materialize, the currency option may be allowed to expire worthless. Thus, the risk profile faced by the hedger can best be...
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