You don't need to be an expert in this area, just need some feedback on overall comprehension and if it seems right for someone with basic understanding. For once I pretty much hit the word limit dead on (9 words short but that's fine) so don't need advice on length although maybe you feel cutting an area or 2 short to make another area longer is in order then let me know.
Compare and contrast the use of futures and options as derivative instruments and in their applications to hedging.
Futures are when a price is agreed before the sale of a good, usually well in advance. The price rarely equals the market price upon sale, sometimes higher and sometimes lower but there is no uncertainty. The most common area futures are used are in farming where farmers cannot be certain of how well the market will be doing during harvest and so agree prices months in advance. The downside to futures is that if the market does a lot better than anticipated, the individual has lost a large amount of potential income.
Options are the opportunity to buy or sell in the future if the price is right. For a premium an individual can request securities to be bought up when their price is below the futures contract and then be sold when above the futures contract. Options are a right but not an obligation, the individual still has the final say on whether or not the securities are purchased or sold. Barrier options are commonly purchased due to the risk factor of being a bet solely on whether or not the security will reach the ﾑbarrierﾒ price. The downside to barrier options is that if the price of the security does not take the correct action by the expiration date of the option then the option expires worthless leaving the individual with what they started less the premium.
Therefore although both are relatively secure derivative instruments, one fixes the individual into a contract whereas the other allows the individual to make a choice after a reccommendation.
Hedging is when an individual purchases what they believe to be an under-priced security and then purchases other related short sale securities in order to offset some of the risk associated with the security they are hoping for a big return from.
Hedging with futures is a way to reduce the risk associated when there is certainty that an asset needs to bought or sold at a later date. A future seller can take a short hedge to lock in the price of delivery while a future buyer can take a long hedge to lock in the price of the purchase. The financial result may not be any better by doing this but as with all futures there is a lot less uncertainty surrounding the actual price when the contract comes to fruition.
Hedging with options is a much more difficult process especially when dealing with barrier options. It is not common practice to hedge with multiple barrier options but in order to work around the situation, investors are known to combine barrier options with normal options. To gain this effect, investors generally have to trade in many normal options in order to obtain the same result as a single barrier option. By trading in so many securities the investor has a lower level risk since it is likely that they will recoup at least a percentage of their investment and is unlikely that all options will result in losses.
Hedging with futures is very common in international businesses which deal with foreign exchange rates. Deals between companies within different areas of the world can often fall apart due to fluctuations in the exchange rates. Without hedging with futures either one of the companies will be worse off than the other on a daily basis, as soon as the exchange rate changes, one company benefits more than another. Hedging with futures therefore sets a price which both parties can agree on for a prolonged period of time rather than worrying about the possibility of the financial integrity decreasing due to a drop in either economy. The futures market in exchange rates is very liquid due to a large number of participants willing to trade their foreign exchange futures. The amplification or leverage of futures where a one percent change in future price can bring about a ten percent change relative to the original investment can be rather risky. The profit increase will gladly be welcomed but a loss could still hurt a company.
Hedging with options is also common practice within the foreign exchange market and also a lot more profitable for buyers due to them having a right but not an obligation to buy or sell whereas sellers, while being obligated to sell should a call option be used, receive a premium by forgoing this right. Hedging with options in the foreign exchange maket works by the buyer purchasing the contracts at a price they want and then either selling upon a reduction in value or allowing the contract to expire if the rate were to appreciate constantly allowing them to forgo the premium but receiving a larger return overall.
The arguments between the two being used in the foreign exchange market ar significant and thus is why both are very commonly used.
Futures remove uncertainty but can result in the exchange rate being worse for the party purchasing them if the market rate were to become more favourable in future. Cash flow can also be a problem as any daily variation which is unfavourable to the contract must be paid for by the trader.
Options on the other hand are safer in that the buyer has the right to sell whenever they wish to on or before the expiration date of the contract. The variation aspect is a characteristic of options rather than the static nature of futures so the margin payment does not apply to options and therefore improves cashflow. The downside to the fact that options are so flexible for the buyer is that they are then more expensive.
In my opinion I would recommend hedging with options within the foreign exchange market due to their flexibility concerning the constantly fluctuating nature of the foreign exchange market, while more expensive they are much more suited as derivative instruments in this sector.
