Financial Risk Manager Part 1

Explanation

Options are financial derivatives that provide the holder with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified period. In the context of foreign exchange, an option would allow ABC Bank to hedge against potential adverse currency movements. If the foreign exchange rate moves in a direction that is unfavorable to the bank, it can exercise the option and exchange the currency at the predetermined rate. However, if the exchange rate moves in a direction that is favorable to the bank, it can let the option expire and exchange the currency at the prevailing market rate. This flexibility is a key characteristic of options and distinguishes them from other derivative instruments such as forwards, futures, and swaps, which obligate the contracting parties to honor the contract.

Choice A is incorrect. Forwards are a type of derivative instrument, but they do not provide the right without an obligation. Instead, they involve an agreement to buy or sell an asset at a specified future date for a price agreed upon today. Therefore, both parties are obligated to fulfill the contract.

Choice B is incorrect. Futures are similar to forwards in that they involve an agreement to buy or sell an asset at a specified future date for a price agreed upon today. However, futures contracts are standardized and traded on exchanges, unlike forwards which are private agreements between two parties. Like forwards though, futures also impose obligations on both parties involved.

Choice D is incorrect. Swaps involve the exchange of cash flows between two parties based on predetermined terms and conditions but do not grant any rights without obligations like options do.