Benefits of a forward contract
A forward contract would not involve payment of a large premium upfront to the counterparty.
A forward contract is a simple arrangement to understand, whereas the basis of calculation of the premium for an over-the-counter (OTC) option may be unclear.
A forward contract gives a certain receipt for the purposes of budgeting.
Drawbacks of a forward contract
A forward contract has to be fulfilled, even if the transaction which led to the forward contract being purchased is cancelled. Exchange rate movements may mean that the contract has to be fulfilled at an unfavourable rate. An OTC option can be allowed to lapse if it is not needed.
A forward contract does not allow the holder to take advantage of favourable exchange rate movements. An OTC option need not be exercised if the exchange rate moves in the holder's favour.
A forward contract may only be available for a short time period, depending on what currencies are involved. An OTC option may be purchased for a longer time period, over a year.
The rate offered on a forward contract will be determined by a prediction based on expected interest rates. The rate offered on an OTC option may be more flexible. This may suit a holder who is prepared to tolerate the risk of some loss in order to have the opportunity to take advantage of favourable exchange rate movements, but who wishes to use the option to set a limit to possible losses.
Reasons why exchange-traded derivatives are used
One of the main reasons why the treasury function uses exchange-traded derivatives is that the contracts can be bought and sold as required. Also, because the markets are regulated by an exchange, counterparty risk (the risk of the other party to the transaction defaulting) should be minimised.
