Risk Hedging with Options

Definition: An Option is an agreement wherein the seller grants the right to the buyer, not the obligation to buy or sell the security at a predetermined price for a specified period of time. Simply, An option is right and does not constitute the obligation on the part of both the sellers and buyers to buy or sell the underlying security at a predefined price during a specified period.

A foreign currency option is the most flexible derivative that helps in reducing the foreign exchange risk. Suppose, there is an Indian manufacturing company that import spares in bulk. The company expects the price of the spares to increase in the future. To tackle such situation the company may buy the options to lock in the price of spares today and take the final delivery on a specified future date. In order to buy the options, the company has to pay a premium to the option seller. In case, the price falls, then the buyer has the right to not to exercise his option and can buy the spares from the spot market.

Also, the options contracts on interest rates and commodities help the managers to manage the financial risk efficiently. Hence, the options provide protection against the risk and benefit from the changes in the currency or price.

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