Why do options provide insurance against foreign exchange risks in bidding situations? Why can't you hedge with a forward contract in a bidding situation?
What will be an ideal response?
Let's assume the bidding situation involves the company determining a particular amount of foreign currency for providing a service or selling some goods. By bidding a fixed amount of foreign exchange, a company incurs a contingent transaction foreign exchange risk. If the company wins the bid and the foreign currency weakens relative to the domestic currency, the domestic currency value of the contractual foreign currency revenue may already have fallen such that the entire dollar profit could be eliminated before the project begins. If the firm's strategy is to get the contract and then hedge, it could be too late.
Foreign exchange options provide a hedging solution. Because the company ultimately wants to sell the foreign currency if it wins the bid, the company should hedge by buying a foreign currency put against the domestic currency. Then, if company wins the contract and the foreign currency has weakened relative to the domestic currency, the loss of value on the contract is offset by a gain in the value of the foreign currency put. The company can sell the foreign currency from the contract at the exercise price, which is higher than the spot market.
If the company does not win the contract, the value of the foreign currency put is the maximum that the firm can lose. This is exactly like an insurance contract.
If the company sells foreign currency forward, it acquires an uncontingent foreign currency liability. No matter what happens at maturity, the company will have to sell a specific amount of foreign currency to the bank. Everything will be fine if the company gets the contract, but if the company does not get the contract, it will have to buy foreign currency to fulfill the uncontingent commitment of the forward contract. If the foreign currency has strengthened, the company will lose money, and the potential loss is essentially unbounded.
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