When is an option contract better than a forward contract for a company?

Because GM's hedging operations constituted a substantial volume of currency trading, GM was

concerned with executing its hedging policies in a cost efficient manner. Forward contracts and

options, however, were not easily comparable on straight cost basis. A forward contract was always

a zero cost contract on the trade date, whereas buying an option involved paying a premium. Thus,

the treasury group needed a different way of analyzing the two strategies with respect to one

another. The framework devised by the Treasury group involved comparing how one strategy or the

other would have fared at the different possible exchange rates that might prevail at the future date

(the date of the exposure to hedge).

Specifically, it compared: (1) the combination of the outright exposure plus a 50% hedge using

forward contracts, with (2) the combination of the outright exposure plus a 50% hedge using options.

On a graph of future spot prices (x-axis) against cash flow payoff (y-axis), these two produced lines

that intersected. That point of intersection represented a sort of break-even pointif GM Treasury's

expected future spot exchange rate was different from that point, GM could choose the strategy that

was more profitable.

Forward contracts Continuing the example from Michel's conversations with traders above,

Michel constructed a spreadsheet that considered a range of future spot rates of 1.4000 to 1.8000 CAD

per USD. The outright exposure measured the foreign exchange gain or loss GM would recognize on

the CAD 20 million position. At a 50% hedge, Michel knew she had to layer on a CAD 10 million

hedge at a forward price of 1.5667. This would produce a partially offsetting cash flow in the future.

The sum of the outright gain/loss and the cash settlement of the forward contract amounted to the

net consequence of a forwards strategy.

Options contracts Instead, Michel could layer on top of the outright exposure just calculated

an option contract purchase. The sum of the outright exposure and the option payoff amounted to

the net consequence of an options strategy. The option characteristics were as described above: a

strike price equal to the forward price of 1.5667 and a premium cost of 1.45% of the notional hedge

amount. When the option was in the money, the contract returned a profit (less the premium),

whereas when it expired out of the money, the gain (loss) on the outright exposure was reduced

(increased) by the premium amount.