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ACCA Applied Skills · Financial Management · Hedging techniques for foreign currency risk

Compared with a forward contract, what is the main advantage of a currency option for a company hedging a future foreign currency receipt?

A currency option protects against adverse exchange rate movements while allowing the holder to benefit if rates move favourably, because it need not be exercised. The cost is a premium, so it is not free and not always better than a forward contract.

  1. AIt removes downside risk while allowing the company to benefit from favourable rate movementsCorrect
  2. BIt has no up-front cost to the company
  3. CIt always gives a better outcome than the forward rate
  4. DIt fixes the exchange rate irrespective of how the spot rate moves

Explanation

An option sets a worst-case rate but lets the holder abandon it if spot is better, at the cost of a premium. The premium means there is an up-front cost. The result is not always better than forward since the premium may outweigh benefits. A rate fixed regardless of movements describes a forward contract.

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