When establishing a business engagement that requires a legally enforceable promise to ensure the implementation in a volatile market
When establishing a business engagement that requires a legally enforceable promise to ensure the implementation in a volatile market. It is the contract which plays a vital role to help the business transaction to managing the risks and opportunities.
In which, the forward contracts and option contracts are derivative instruments which can be used for hedging foreign exchange risk. The hedger desires to modify or even eliminate the risk of price fluctuation by locking in a purchase price of underlying asset through a long position (buyer) or a sales price through a short position (seller).
The forward contract is defined as a vehicle for exchanging a certain underlying asset at a specified price today, called delivery price and it is exercised at a specified time in the future, called maturity date.
In essence, forward contract obviously help to create stability and protect against exchange rate fluctuation for both ends of transaction related to an exact pre-calculated amount of money. Afterwards, the cost of forward hedging may be realized ex-post when the hedger might have to suffer. The buyer can buy now and pay later to lock in guaranteed profit in case the exchange rate changes to go up in maturity point of time. In the meanwhile, the seller has to accomplish the liability of delivery to counterparty, resulted in a loss. That means a constrain of a forward contract is a zero-sum game. Although forward contract limits the losses in the case of unfavorable change in exchange rate, it also limit extra profits that are entitle to get in the event of a favorable movement in exchange rate.
A forward contract exits as a tailor-made agreement between two parties for a transaction that is scheduled to take place in the future without standardization and get traded in over the counter market (OTC). So one advantage of this kind of customized contract is flexibility based on whatever mutual counterparties tend to agree to. The buyers can negotiate for advantageous payment terms but they need to consider a term of single payment. Also, it is sometimes agreed on the trust between long and short position instead of required collateral. On the contrary, this lack of collateral shows that forward contracts involve credit risk. Problems may arise if one of the participants fails to perform i.g. bankrupt. To prevent this default risk, a small certain deposit is appointed at a corporate bank by long position that leads to the inflexibility in reinvestment of capital. In addition, one disadvantage of a forward contract is it is non-transferable and quite illiquid, meaning it is less marketable or cannot resold to third parties else due to the nature given of customized contract,.
An option contract is a standardized contract giving the holder the right, but not the obligation, to buy or sell a given quantity of an underlying asset at price agreed upon today (striking price) at some time in the future. As a consequence, there are two different types of options, which are call option and a put option, cover all potential transactions. The call option gives the holder the right, but not the obligation, to buy a given quantity of some asset at a specified rate at a determined date and the put option gives the holder the right, but not the obligation, to sell a given quantity of some asset at a specified rate at a specified date. There are two kinds of options based on expiration date, European options which can only be exercised on the expiration date while American options can be exercised at any time up to and including the expiration date.
Unlike the forward contract, the option gives the buyer (long position) the right to decide
whether or not the trade will eventually exercise. On the other hand, the seller (short position) is strict obligated to the buyer under the terms of agreement if the buyer chooses to perform the option.
So with the options, the major comparative advantage is that holders can take an advantage of flexibility to trade any type of potential move in the underlying asset, offer more strategic investment alternatives with any expiry date by using multiple options strategies to play as well as liquidity. Using a covered call strategy, or selling options against shares that you already own is also a good method to earn extra income from shares you’re already hold. Obviously, options are excellent tools for the buyer in term of cost efficiency regardless to trade upward or downward or even sideway price movements. Thus, it is clear to offer incredible leverage higher profit potential as well prevent from loss versus less risky.
Nevertheless, main disadvantage of options contracts come with the premium paid for the contracts upfront in any circumstance of fluctuation in exchange rate. This amount of premium will goes to be worthless expiry and wasted if the options contract is not exercised. Also, the flexibility in nature of options strategies requires investors have to closely monitor the market fluctuation and analyze complex criteria such as hedge ratio. Moreover, in case of buyer wants to exercise, such taking potentially unlimited loss by seller in term of uncertain exchange rate risk is clear disadvantage. So that the seller is to carefully consider about the terms of contract as well as implementation conditions.
All in all, both of the option contracts and forward contracts have different advantages and different disadvantages so totally they depend on the purpose, expectation, needs and business model of investors. The participants need to consider, analyze carefully before select one of them, option or forward.