Last updated on Feb 1, 2024
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What are forward contracts and options?
2
What are the advantages of forward contracts?
3
What are the disadvantages of forward contracts?
4
What are the advantages of options?
5
What are the disadvantages of options?
6
Here’s what else to consider
If you are a business owner or manager who deals with foreign currency transactions, you know how important it is to manage your cash flow and hedge your currency risk. One way to do that is to use derivatives, such as forward contracts or options, to lock in favorable exchange rates and protect yourself from unfavorable fluctuations. But which one is better for your cash management needs? In this article, we will compare the pros and cons of using forward contracts vs. options for cash management.
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1 What are forward contracts and options?
Forward contracts and options are both types of derivatives, which are financial instruments that derive their value from an underlying asset, such as a currency. A forward contract is an agreement between two parties to exchange a certain amount of currency at a specified rate and date in the future. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain amount of currency at a predetermined rate and date in the future. The buyer pays a premium to the seller to acquire this right.
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Both instruments are derivatives and it is recommended a good knowledge of them before start a negotiation.In my experience, companies use forward contract to hedge on currencies volatility.Options are used to give bonuses to managers such as stock options. I never use options to cash management operations.Another derivative frequently used is SWAP. Usually, with this type of contract, you can transform assets or liabilities from variable rate to fixed rate and viceversa.One thing I've found helpful is to trust about my finance partner such as banks and payment providers. I never search other partner to work only with derivatives.One of the best practice is to link derivative operations with standard ones.
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- Karim Farah, Mini MBA Accounts payable Team lead at CMA CGM
Forward contracts offer simplicity and certainty but come with the obligation to fulfill the contract. Options provide flexibility and limited risk but involve premiums and added complexity. The choice depends on specific needs and risk tolerance in cash management.
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2 What are the advantages of forward contracts?
Forward contracts have some advantages over options for cash management. First, they are cheaper and simpler to use, as they do not involve any upfront fees or premiums. Second, they offer certainty and protection, as they eliminate the exposure to currency risk and lock in the exchange rate for the future transaction. Third, they are flexible and customizable, as they can be tailored to the specific needs and preferences of the parties involved.
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Forward are OTC contract (not negotiate in a official stock market but "over the counter") so you can custom them during the agreement.As a type of derivatives they are simple to use and understand (e.g. you can lock an exchange rate until a specific date and your company can continue operate without exhange rate fluctuations).
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3 What are the disadvantages of forward contracts?
Forward contracts also have some disadvantages over options for cash management. First, they are binding and inflexible, as they oblige the parties to fulfill their obligations regardless of the market conditions. This means that they can result in opportunity costs or losses if the exchange rate moves in favor of the other party. Second, they are subject to credit risk and default risk, as they depend on the ability and willingness of the counterparty to honor the contract. Third, they are not standardized or regulated, as they are traded over-the-counter (OTC), which means that they may lack transparency and liquidity.
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The main disadvantage for forward contract is they are inflexible. If exhange rate changes bring you some income you have to respect conditions define in forward contract.
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4 What are the advantages of options?
Options have some advantages over forward contracts for cash management. First, they offer flexibility and choice, as they give the buyer the option to exercise or not exercise the contract depending on the market conditions. This means that they can benefit from favorable movements or limit losses from unfavorable movements in the exchange rate. Second, they limit the downside risk and enhance the upside potential, as they only require the buyer to pay a premium and not the full amount of the underlying currency. Third, they are standardized and regulated, as they are traded on organized exchanges, which means that they have more transparency and liquidity.
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Option are more flexible than forward contract because at a specific date you can decide if you want to exercise or not the contract.
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- Dimi G. Velea Equity Derivatives Trader at Cross Options Group
You can create a synthetic long forward contract with options only. The beauty of the Put-Call Parity.Take the ATM strike. If you buy the Call and sell the Put, your pay-out graph will look like a long Forward contract. Both legs give you long deltas and it should not cost anything.
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5 What are the disadvantages of options?
Options also have some disadvantages over forward contracts for cash management. First, they are more expensive and complex to use, as they involve upfront fees or premiums that reduce the net profit or increase the net loss of the transaction. Second, they are subject to time decay and volatility risk, as they lose value as they approach their expiration date and as the market becomes more uncertain. Third, they may not fully hedge the currency risk, as they depend on the strike price and the spot price of the underlying currency.
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First of all options are more complex than forward contract and if you want to buy an option you have to pay a premium and it will reduce your profit.
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6 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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When considering the choice between using forward contracts and options, it is crucial to remember that managing a company involves considering a multitude of factors and processes. A comprehensive reflection of a company's operations is encapsulated in its budget or forecast for the upcoming period, presented in the form of cash flow forecasts and profit and loss projections. The decision to use forwards or options stems from what you aim to hedge or manage with these contracts.In the presence of specific risks, such as currency risks, forward contracts offer the advantage of risk elimination without additional expenses. This is why the majority of companies not specializing in financial operations opt for forward contracts.
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