Hi, The following is an excerpt from the Currency Risk Management section on whether to use futures or options to hedge a foreign currency position. The logic given here seems a bit counter intuitive. I think a manager should use futures if has no opinion on the direction of the rates and should use options when she has an opinion on the direction. Please comment. ‘Whether to use options or futures actually depends on the manager’s expectations. If the manager expects ex rates be volatile but has no strong feeling for the direction they will go, he should use options. If manager is primarily concerned with unfavorable movements he will use futures.’ Thanks, MG.
If a manager doesnt know the direction then he will use options b/c if the FC appreciates its beneficial and he shares in that appreciation minus premium cost, if the FC depreciates he can excercise the option and lock in a favorable FX rate. If the manager is certain that the FC is going to depreciate he can lock in a rate with a futures contract for no cost, however if the FC appreciates he will have a potential big cost depending on how far it depreciates as he has to pay the other side, its not an asymmetric payoff like options are…
I would say that a market that trades $10,000,000,000,000/day is likely to be pretty efficient and the manager’s opinion is totally irrelevant. The decision to use options or futures (or swaps or forwards or futures options all of which are highly liquid) depends on the risk being hedged.
Malhar Wrote: ------------------------------------------------------- > Hi, > > The following is an excerpt from the Currency Risk > Management section on whether to use futures or > options to hedge a foreign currency position. The > logic given here seems a bit counter intuitive. I > think a manager should use futures if has no > opinion on the direction of the rates and should > use options when she has an opinion on the > direction. Please comment. > > ‘Whether to use options or futures actually > depends on the manager’s expectations. If the > manager expects ex rates be volatile but has no > strong feeling for the direction they will go, he > should use options. If manager is primarily > concerned with unfavorable movements he will use > futures.’ > > Thanks, > > MG. You can also argue that Options values increase with volatility. So if you’re expecting an increase in volatility you should buy options. that in addition to the asymmetry of the pay-off that BigWilly talked about.
JoeyDVivre Wrote: ------------------------------------------------------- > I would say that a market that trades > $10,000,000,000,000/day is likely to be pretty > efficient and the manager’s opinion is totally > irrelevant. The decision to use options or > futures (or swaps or forwards or futures options > all of which are highly liquid) depends on the > risk being hedged. This makes sense, but feels too abstract for me. What are the key features of a risk that would determine whether one should use a future vs. an option. I figure the following: Futures are there either 1) to lock in an outcome, or 2) make a leveraged bet on an outcome. Options are there either to 1) limit losses to a maximum, 2) gain a premium for selling someone else insurance (which has theoretically unlimited losses), 3) make a bet on volatility. Anything else?
All the FX derivatives have some combination of interest rate risk, changing hedge exposure due to time or underlier movement, counterparty risk, vol risk, marked-to-market risk, accounting risk, etc. It really depends on what the risk is you’re trying to hedge. The big problem with futures is the MTM which can kill you if you are not liquid (check out Metallgesellschaft), that they have defined expiration dates, are not especially liquid in big size compared to Interbank markets, there is a significant interest rate component to longer dated ones. The problems with options might be counterparty risk (depends), need to change hedge with time decay, poorly understood gamma and vega risk, up front expense or unlimited risk.