They offer hedging at a pre-defined rate, opportunities to gain some benefit from favourable market moves, and total protection against losses.
What is a participating forward?
A participating forward is a hedging strategy that can be customised for protection against unfavourable movements in the exchange rate. The option allows some benefit from favourable moves. It may offer a better rate than other risk management solutions such as collar options.
When setting up a participating forward, you can select the currency pair, define the duration of the contract, and set the nominal amount for the expiry and participation ratios. Two scenarios may occur when a participating forward expiry is reached:
- The fixing rate is at or higher than the strike rate, in which case you may sell the notional amount at the strike rate.
- The fixing rate is below the strike rate, in which case you must sell 50% of the notional amount at the strike rate. You are under no obligation with regard to the remaining 50% of the notional amount.
The outcomes listed above are applicable to a business that is exporting to an international market.
One of the benefits of participating forwards is that, like collar options, they are zero-premium strategies. Other benefits include complete protection against unfavourable exchange rate movements and an uncapped upside on 50% of your notional.
The possibility of paying a substantial cost if you terminate the trade before the expiry date is one of the risks. Another risk is that the option is subject to margin calls that may require you to make cash deposits during the period in which the contract is active.
Participating forward example
This example explains the basics of participating forward FX options:
A London-based company that focuses on imports must pay US$250,000 to a US-based supplier six months from now. The company wants complete rate protection and a favourable exchange rate but does not want to pay a premium.
The forward rate for the six-month period is 1.3600. The worst-case rate that the company is prepared to accept is 1.3400, so the company buys a participating forward that offers a 1.3400 protected rate and a 50% participation proportion.
If the exchange rate moves unfavourably when the contract expires, such as to 1.3000, the company can buy the full US$250,000 at 1.3400. If the exchange rate moves favourably, up to 1.4200, the company is obliged to buy 50% at 1.3400, but may buy the remaining US$125,000 in the spot market at 1.4200. The effective rate therefore, is 1.3700.
Knock-out participating forward
A knock-out participating forward FX option adds a knock-out element to a contract that may offer limited participation in advantageous rate movements and protection against disadvantageous movements.
If the currency pair reach the knock-out rate or above during the observation period, all future expiry dates will be knocked out. These contracts have additional risks, such as a lack of control over the transaction’s tenor and the possibility of re-hedging at a higher rate than at the initial trade time.
Extendible participating forward
Extendible participating forwards include the option of extending the period of the contract before the expiry date is reached.
There are a few additional risks associated with the product. One is that extending the contract could lead to over-hedging. Another is that extending the contract will lead to the rates being worse than the prevailing market rates when it expires.
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