Question

You are CFO of FlyByNight, Inc. and you are trying to decide whether to hedge foreign currency receivables and payables. One member of your team strongly favors forward contracts while another feels strongly about options. In addition, other team members are ambivalent. What are the advantages and disadvantages of both forward contracts and options. What method do you recommend, if any? You must support your answer.

Answer 1

Forward options are tailor made contracts, the parties to the contract agrees to buy or sell a specific asset at a future date at a price decided at the time of initiation of contract. It doesn't require any margin payments like future Contracts.

But yes, you are under an obligation to fulfill the contract.

Options are the right to buy or sell an asset at a specified price at a specified maturity. Options gives the holder right but not obligation.

When the management or the trader feels strongly about the market movement wether it will be bullish or bearish they can use forward contracts as that will assure fulfillment. But if they are not sure about the market movement its better to use options for Hedging because if you don't exercise the option on maturity the option expires worthless, the only gain/loss would be of premium received/paid.