How is hedging exchange rate exposure using options different from hedging using forward contracts? What does this suggest about the costs of hedging with options rather than forwards?
Hedging exchange rate exposure using forward contracts:
Once a company has established an obligation to pay an amount of foreign currency, its costs are exposed to fluctuations in the foreign exchange market. These risks can be eliminated through the use of a forward contract, which allows it to purchase a specified amount of foreign currency at a current rate of exchange for delivery on a set date, typically between a month and a year in the future. Forwards can be bought or sold versus the U.S. dollar to cover both foreign payables and receivables. Once the exchange rate is locked in, the U.S. dollar amount is set for the duration of the agreement regardless of subsequent market movements. You will not ...
This posting examines in detail as to how hedging exchange rate exposure using options is different from hedging using forward contracts and the advantages of the former.