A Comparison of the Effectiveness of Currency Futures and Currency Options in the Context of Foreign Exchange Risk Management

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CHAPTER I INTRODUCTION 1.1. Research Background Exposure risk managers can hedge exchange rate risk with either currency futures or currency options. It is generally suggested that hedgers should choose a hedge instrument that matches the risk profile of the underlying currency position as closely as possible. This advice, however, ignores the possibility that the hedging effectiveness may differ for the alternate risk management tools. This study compares the effectiveness of currency futures and currency options as hedging instruments for covered and uncovered currency positions. Based on Ederington 's (March 1979) portfolio theory of hedging, the results show that currency futures provide the more effective covered…show more content…
Since currency futures and currency options are written on the same underlying spot currency, the two markets are clearly linked. By combining a call and a put with the same terms (exercise price, maturity date, and spot currency) and borrowing or investing the difference between the put and the call, an options synthetic futures contract is created which theoretically is equivalent to a futures contract. Alternatively, each market may occupy a specialized market position, serving customers with particular needs. Based on a previously done research on comparing currency futures and currency options as a hedging instrument. Chang and Shanker (Summer 1986) provide a preliminary comparison of the hedging effectiveness of futures and option synthetic futures contracts. Based on a risk-return framework, the authors find that currency futures provide a more effective hedge for a covered position than do currency option synthetic futures. Thus, for a covered hedge, futures offer both an appropriate risk profile and greater hedging effectiveness. These results, however, must be interpreted with caution. First, Chang and Shanker (Summer 1986) used data from the first year of options trading at the International Options Market of the Montreal Exchange. Thus, lack of liquidity and depth of the options market may have contributed to the findings of their study.

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