From a hedging perspective, which is the better derivative, the option or the future?
By using options, it’s possible to construct hedges that work like filters. The options can filter out the effects from negative price movements and let only the positive price movements affect the company. A company that wants to hedge itself from high market prices on energy can choose to buy call options instead of buying energy with forwards or futures. Doing so the company buys the right to purchase energy at a predetermined price but doesn’t have to buy at that price if the market price falls. The company is free to buy energy in the market instead and save costs. By choosing options instead of forwards the company are not obliged to buy at higher price than market price.
An energy producer can choose to buy put options to buy the right to sell at a predetermined price. If the market falls below that price the company uses the option to sell and if the market increases above the price the option stipulates, the company sells at the higher market prices receiving higher revenue than it would using forwards as hedges.
Using options allows the companies to be opportunistic but still being hedged. Whether the company wants to hedge cash flow, balance sheet, competitive strength or potential future deals, options allows for all of that without limiting the company’s profitability to the value given by the market.
Options come with a premium that sometimes may be perceived as substantial and expensive. The option premium is a cost and should be valued as the price a company would be pay for security of downside but still having the opportunity of the upside.
Are options superior to forwards and futures? Options provide more flexibility and still control risk. As the strikes can be set relatively flexible it is possible to buy protection at prices that are quite far from the current market. It is possible to create different levels of protection at various cost levels. On the negative side is the option premium which by many is perceived as cost as it is a visible payment done upfront normally. The premium has to be assessed relative the potential upside or protection the option provides
The linear instruments, forwards and futures, are good instruments in the sense they provide transparent future prices with no premiums to pay upfront. They fix the future price, based on today’s market, and the seller and buyer are committed to that price regardless of the market in the future. On the downside is the margining that is required by banks and clearing houses. The margining potentially draws liquidity before revenues are delivered from the good that is hedged
The choice is really between buying flexibility for a premium or fix future prices with out premiums. Both types offers protection and transparency. The company´s liquidity is affected by both types, one up front and known in the form of premium, the other in the form of margining which eventually should be matched with liquidity from the hedged good. With proper understanding of the derivatives all should be included in the risk management toolbox and as they have different purposes and uses. In some occasions the company may afford to buy more flexibility and in some occasions the company may be limited to fixed prices. Risk management needs to be a fully integrated part in budgeting, prognosis and business development work to add as much value as possible.
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