Financial Risk Manager Part 1
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In light of the CFO's analysis, how does the efficacy of using an option for hedging purposes compare to that of employing a forward position? Provide a detailed comparison of the two strategies, considering their potential benefits and drawbacks in mitigating financial risk.
In light of the CFO's analysis, how does the efficacy of using an option for hedging purposes compare to that of employing a forward position? Provide a detailed comparison of the two strategies, considering their potential benefits and drawbacks in mitigating financial risk.
Explanation:
The CFO's analysis is incorrect because there is unlimited downside risk. The option premium received is a fixed amount, and if the EUR depreciates sharply, the value of the underlying receivable goes down as well. If the company had taken a forward contract, they would have locked in the exchange rate and thus mitigated the risk of currency depreciation. Selling a call option exposes the company to the risk of a significant loss if the EUR depreciates, as they would not only miss out on the potential appreciation but also suffer from the reduced value of their receivables. The premium from the option does not compensate for this risk. Therefore, the correct answer is D, as the CFO's analysis does not account for the potential downside risk associated with selling a call option.