Question

31.) the major disadvantage of forward and futures contracts relative to options is that the forwards and futures contracts a) cannot protect the holder against the risk of adverse movements in exchange rates b) are more expensive c) are available only for relatively short maturities d) eliminate the possibility of gaining a windfall profit from favorable movements in exchange rates

Answer 1

The major disadvantage of forward and futures contracts relative to options is that forwards and futures contracts cannot protect the holder against the risk of adverse movements in exchange rates. Unlike options, which offer flexibility in responding to market conditions, forwards and futures contracts lock in an exchange rate, exposing the holder to potential losses if the market moves unfavorably.Thus the correct option is:a) cannot protect the holder against the risk of adverse movements in exchange rates.

Step-by-step explanation:

Forward and futures contracts expose the holder to the risk of adverse movements in exchange rates. Unlike options, which provide a way to hedge against unfavorable currency movements, forwards and futures contracts lock in an exchange rate at a future date but do not offer protection if the market moves against the holder.

To elaborate, consider an investor entering into a forward contract to buy a foreign currency at a specified exchange rate in the future. If the exchange rate depreciates, the investor is still obligated to buy the currency at the agreed-upon rate, resulting in a loss. Options, on the other hand, allow the holder the flexibility to choose whether to exercise the option based on market conditions.

In conclusion, while forwards and futures contracts serve as tools for hedging against exchange rate risk to some extent, they lack the protective features found in options, making them less effective in safeguarding against adverse currency movements. This limitation is a crucial factor for businesses and investors to consider when choosing the most suitable financial instrument for managing currency risk.Thus the correct option is:a) cannot protect the holder against the risk of adverse movements in exchange rates.

Answer 2

Forward and futures contracts cannot protect the holder against the risk of adverse movements in exchange rates, unlike options.

Step-by-step explanation:

Forward and futures contracts have a major disadvantage compared to options in that they cannot protect the holder against the risk of adverse movements in exchange rates. This means that if the exchange rate moves unfavorably, the holder of a forward or futures contract will not be able to mitigate their losses. On the other hand, options provide the holder with the right, but not the obligation, to buy or sell a specific amount of currency at a predetermined price, allowing them to protect themselves from adverse movements in exchange rates.

For example, let's say a U.S. firm signs a forward contract to buy euros at a certain exchange rate in the future. If the exchange rate between the U.S. dollar and the euro becomes less favorable, the firm will still have to buy the euros at the predetermined rate, resulting in a loss. However, if the firm had purchased a currency option instead, they could choose not to exercise the option if the exchange rate becomes unfavorable, thus avoiding a loss.