Hedging With Option Contracts

The contracts we have discussed thus far—forwards, futures, and swaps—are conceptually similar. In each case, two parties agree to transact on a future date or dates. The key is that both parties are obligated to complete the transaction.

In contrast, an option contract is an agreement that gives the owner the right, but not the obligation, to buy or sell (depending on the option type) some asset at a specified price for a specified time. Options are covered in detail elsewhere in our book. Here we will only quickly discuss some option basics and then focus on using options to hedge volatility in commodity prices, interest rates, and exchange rates. In doing so, we will sidestep a wealth of detail concerning option terminology, option trading strategies, and option valuation.

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