Foreign Currency Futures and Options

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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

Similarities: 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

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