United StatesChange Country

Dissecting Derivatives: Forward Contracts, Futures Contracts, and Options

By Megan Doyle

Foreign exchange risk can be one of the biggest challenges companies face when conducting business internationally. While FX risk will never be eliminated, several types of financial derivatives offer companies flexible ways to hedge against FX losses.

This article explores the advantages and disadvantages among forward contracts, futures contracts, and options, and how businesses—both large and small—can use these derivatives to hedge against FX risk. A “derivative” is simply a contract whose value is based upon—or derived from—an underlying asset, in this case the foreign exchange rate of a currency pair.1

 

Forward Contracts are Private, Non-Standardized Derivatives

 

Among the most straightforward currency-hedging methods is the forward contract, a private, binding agreement between two parties to exchange currencies at a predetermined rate and on a set date up to 12 months in the future. In other words, the parties agree upon an exchange rate to hedge against currency fluctuations and increase their financial certainty.2

 

Notably, forward contracts are non-standardized and unregulated, hence their private nature. As such, they are traded “over the counter” (OTC) between two parties, rather than through a public derivatives exchange. Because they are not standardized, forward contracts can be customized to each party’s needs. However, forward contracts cannot be traded in a secondary market, and each party is committed to the currency exchange on the contract’s expiry date.

 

Other types of forward contracts include window forwards, which allow the exchange to take place at any point between two set dates,3 long-dated forwards (for more than a year up to 10 years)4 and non-deliverable forwards (in which the difference in value between the two currencies is delivered, rather than the currency itself).5

 

Futures Contracts are Publicly Tradeable FX Hedging Tools

 

Like a forward contract, a futures contract is an agreement to exchange currencies at a predetermined rate on a specific date in the future.6 Unlike forwards, futures contracts are publicly traded on a futures exchange, such as The Chicago Mercantile Exchange. Because futures are publicly traded, they are standardized and regulated by clearinghouses that work to ensure that the quality and quantity of the transaction are upheld.7

 

At expiration of a futures contract, the buyer is required to purchase the underlying currency, while the seller is obligated to provide the underlying asset. Unlike forwards, however, futures can be publicly traded prior to the established expiry date. Futures may be traded purely for profit or if a business changes its mind about the initial transaction, for example.8

 

Because futures can be settled at any point during the contract’s life, their value is determined on a daily basis, called the “mark to market.” The mark to market continues until the futures’ expiry date.

 

Options are a More Versatile—and Complex—Currency-Hedging Strategy

 

Options also allow businesses to buy or sell a set amount of currency at a specified exchange rate. However, currency options offer more flexibility for making exchanges.

 

Basic options, known as “plain vanilla” options, are the simplest and most common type of option.10 They are always conducted in “put and call pairs,” meaning each transaction entails a sale (“put”) and a purchase (“call”). Notably, options give businesses the opportunity, not obligation, to “strike” at the agreed upon exchange rate on or before the established expiry date, depending on the style of option.

 

American-style options, for example, can be exercised before the expiry date, while European-style options can be exercised only on the expiry date. American-style options can create more opportunities for businesses to benefit from favorable FX movements, but they often come at a higher premium.11

 

Options are standardized in accordance with the International Accounting Standards Board’s International Financial Reporting Standards (IFRS).12 Like futures contacts, they can be traded in public exchanges, but most options buyers and sellers trade directly with each other over the counter, as with forward contracts.13 OTC options are not standardized, but they may be cleared by a central clearinghouse to protect each party.14

 

Exotic Options and Combining Multiple Hedging Strategies

 

Those with more complex FX risk management needs, including international businesses that want to manage the volatility of multiple currencies, may turn to “exotic” options. There are many types of exotic options, all of which tend to have non-standard features, enabling them to be tailored to individual risk management needs, and they may involve a stack of multiple options contracts.15

 

Because they’re customized to each party, they’re always traded OTC instead of through a derivatives exchange. However, in exchange for customizability and flexibility, exotic options usually put some of the company’s capital at risk. Regardless, depending on a business’ needs, exotic options may be a more affordable and effective FX hedging strategy than forwards, futures, or basic options.

 

Even-more sophisticated FX options can give businesses longer-term “structured” protection by customizing combinations of two or more underlying currency-hedging methods, such as an options contract and a forward contract.16 Without proper planning, however, such structured options can quickly get convoluted, so businesses may wish to proceed cautiously.

 

The

Takeaway:

Companies looking to hedge against foreign exchange risk have several methods at their disposal. Any company doing business internationally—including small and midsize enterprises—may wish to learn more about the different advantages and disadvantages of forward contracts, futures contracts, and forex options.

Megan Doyle - The Author

The Author

Megan Doyle 

Megan Doyle is a business technology writer and researcher based in Wantagh, NY, whose work focuses primarily on financial services technology.

Sources

1. “What is a Derivative?,” Investopedia; https://www.investopedia.com/ask/answers/12/derivative.asp
2. “Forward Contract Definition,” Investopedia; https://www.investopedia.com/terms/f/forwardcontract.asp
3. “Foreign Exchange Risk,” Export.gov; https://www.export.gov/article2?id=Trade-Finance-Guide-Chapter-14-Foreign-Exchange-FX-Risk-Management
4. “Long Dated Forward,” Investopedia; https://www.investopedia.com/terms/l/long-date-forward.asp
5. Understanding FX Forwards, Microfinance Currency Risk Solutions; http://www.microrate.com/media/docs/investment/V-Guide-to-FX-Fowards.pdf
6. “Futures Contract,” Investopedia; https://www.investopedia.com/terms/f/futurescontract.asp
7. “Explaining Forward and Futures Contracts,” Investopedia; https://www.investopedia.com/video/play/explaining-forward-and-futures-contracts/
8. “How to Use Currency Hedging to Protect Your Import or Export Business,” All Business; https://www.allbusiness.com/how-to-use-currency-hedging-to-protect-your-import-or-export-business-15051093-1.html
9. “Explaining Forward and Futures Contracts,” Investopedia; https://www.investopedia.com/video/play/explaining-forward-and-futures-contracts/
10. “Vanilla Option,” Investopedia; https://www.investopedia.com/terms/v/vanillaoption.asp
11. “Currency Options Explained,” Forex Traders; https://www.forextraders.com/forex-education/forex-fundamental-analysis/currency-options-explained/
12. “IFRS 9 – Financial Instruments,” IAS Plus; https://www.iasplus.com/en/standards/ifrs/ifrs9
13. “OTC Options,” Investopedia; https://www.investopedia.com/terms/o/otcoptions.asp
14. Basle III and CCP Promotion,” Finmarkets; https://www.fimarkets.com/pagesen/OTC_derivatives_CCP.php
15. “Exotic Options,” Investopedia; https://www.investopedia.com/terms/e/exoticoption.asp
16. “10 Options Strategies to Know,” Investopedia; https://www.investopedia.com/trading/options-strategies/

Related Articles

What is FX Hedging? Rolling Hedges and Short Hedges
New Accounting Rules Add Clarity, Flexibility to FX Hedging and Reporting
Simple FX Risk Hedging for SMEs