Hedging Efficiency of Forward and Option Currency Contracts

Abstract

This paper compares the foreign exchange hedging efficiency of forward and option currency contracts. Previous studies tend to concentrate on the risk reducing aspect only. They suggest that options seldom are more efficient in reducing foreign exchange risk than forwards or futures. The hypothesis of this paper is that this is due to: 1) the use of the variance a a risk measure, or 2) the assumption that foreign cash flows are non-contingent and certain. This paper reports the results of an analysis which evaluates hedging alternatives in an expected value-risk space. Risk is measured by a probability-weighted function of deviations below a specific target level. Furthermore, both contingent and non-contingent uncertain foreign currency cash flows are analysed. The analysis shows that options tend to dominate forward contracts. Hence options tend to be preferable if the investor is concerned about avoiding returns below the target level, while forward contracts tend to be preferable if the investor measures risk by the variance. Finally, the maximum risk reduction from using options or forward contracts is not very large, except if the foreign currency cash flow and the exchange rate are highly (positively or negatively) correlated.