Describe qualitatively how changing the strike price of the option provides either more or less expensive insurance

Question

What will be an ideal response?

Answer 1

Let's consider hedging a foreign currency receivable with a put option. High-quality insurance in this context means that the floor we create on our domestic currency revenue is high. The floor is directly related to the strike price of the put option. The higher the strike price of the option, the less the foreign currency must depreciate before we can exercise the option and cut our losses. But, just as insurance that covers more losses is more expensive, put options with higher strike prices are more expensive. Thus, if the foreign currency strengthens and you do not need the insurance of the put option, you will have spent more money on the insurance and will need more appreciation of the foreign currency before you do better than you could have by locking in a forward contract.