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Discuss the pros and cons of using forwards or options to hedge financial risk. Should firms...

Question:

Discuss the pros and cons of using forwards or options to hedge financial risk.

Forwards or Options

A very simple definition of forwards or options is that they are basically agreements to buy or sell some amount of something at a future date at a predetermined price. This is helpful when the price of that item fluctuates often. (Now, it is much more complicated than this, but we will keep it at this simple level for now.)

Answer and Explanation:

An option or forward can help reduce the risk of losses. There is inherent risk in these investments compared to other types of securities but this also gives the potential to create dramatic returns. If the market price for that item drops well below your predetermined price, you win. However, the counterpoint is that the risk of losses is also high as the market may go higher than your predetermined price and you lose. There may also be upfront costs for the option.


Learn more about this topic:

What is a Forward Contract? - Definition & Examples

from Business Law: Tutoring Solution

Chapter 6 / Lesson 22
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