Question

‘Options are sometimes criticised as being merely a tool for speculative investing. However the existence of option contracts allows companies to engage in the hedging of corporate risks which can have significant benefit for shareholders’.

Critically discuss the above statement. Outline some specific examples of corporate hedging using option contracts.

Answer 1

Its true as said here - 'Options are sometimes criticised as being merely a tool for speculative investing' but options are a very effective way of hedging risks for corporates for the benefit of shareholders. So options allow the corporate to exercise the contract at a specific price and during a specific time frame. They are means of hedging as they provide them the option and not the obligation to reduce corporate risk. So for example - a corporation is into construction business and the management knows that an input for production may rise in price in future. So in order to reduce the risk for stakeholders, they can buy call option in future on exchange so if in future the price of steel rises in the market, the corporate can exercise the option at a lower price and compensate for the higher price in market. Vice versa is the case with put option. So not just for speculation options have great hedging capabilities.