· Options Market Hedge

In many circumstances, the firm is uncertain whether the hedged foreign currency cash inflow & outflow will materialize (turn up). Currency options obviate this problem.

There are two kinds of options.

A PUT OPTION gives the buyer the right, but not the obligation, to sell a specified number of foreign currency units to the seller at a fixed price up to the option’s expiration date.

Alternatively, a call option is the right, but not the obligation, to buy a foreign currency at a specified price, up to the expiration date.

A CALL OPTION is valuable, for example, when a firm has offered to buy a foreign asset, such as another firm, at a fixed foreign currency price but is uncertain whether its bid will be accepted.

The GENERAL RULE to follow when choosing between currency options & forward contracts for hedging purposes are summarized as follows:

1. When the quantity of a foreign currency cash outflows is known, buy the currency forward, when the quantity is unknown, buy a call option on the currency.

2. When the quantity of a foreign currency cash inflow is known, sell the currency forward, when the quantity is unknown, buy a buy option on the currency.

3. When the quantity of foreign currency cash flow is partially known & partially uncertain, use a forward contract to hedge the known portion & an option to hedge the maximum value of the uncertain remainder.