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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against forex risk

Which of the following is the most accurate statement when comparing a forward contract with a currency option for hedging a future foreign currency receipt?

A currency option protects against adverse movements while permitting gain from favourable ones, but it costs a premium paid up front. A forward is binding and fixes the rate, so it removes both downside and upside.

  1. AThe option removes downside risk while allowing benefit from favourable rate movements, at the cost of an upfront premiumCorrect
  2. BA forward contract allows the company to benefit from favourable rate movements but has no cost
  3. CAn option fixes the exchange rate exactly, with no premium payable
  4. DA forward contract is a right but not an obligation to exchange currency

Explanation

Options give the right, not the obligation, so the holder can walk away if the market rate is better, but must pay a premium. Forwards are binding and fix the rate, removing upside as well as downside.

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