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

Which statement about hedging a foreign currency receipt with an over-the-counter currency option, compared with a forward contract, is correct?

A currency option protects against adverse rate movements while letting the holder benefit from favourable ones, because it is a right and not an obligation. The price of this flexibility is the premium payable at the start, unlike a forward contract.

  1. AThe option fixes the exchange rate exactly, as a forward does, but costs more
  2. BThe option removes downside risk while retaining upside potential, at the cost of a premium paid up frontCorrect
  3. CThe option has no cost because the premium is recovered through the exercise price
  4. DThe option must always be exercised at maturity, so it is equivalent to a forward

Explanation

A purchased option gives the right but not the obligation to deal, so the holder can abandon it if the market rate is better. This flexibility is paid for by the premium. A forward fixes the rate with no premium but no upside.

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