A forward extra structure provides a secured protected rate, while still allowing beneficial moves up to a pre-determined trigger level. If the trigger level is met or exceeded at any time during the life of the trade, the holder of the forward extra is obliged to deal at the protected rate.
If the rate on expiry is in-between the trigger level and protected rate, the holder of the forward extra can transact at the spot rate. If the spot rate at expiry is less favourable than the protected rate the holder of the forward extra can transact at the protected rate. Forward extras are generally structured as zero-cost premium products.
An example of how a forward extra works
A UK-based company imports materials from the US and needs to pay a supplier $500,000 in six months’ time.
- would like to benefit from a favourable exchange rate and 100% rate protection
- is willing to pay a premium for this
2. Current Forward Rate
The forward rate for a six-month period is
The company is prepared to accept a worst-case rate of 1.3200. The company buys a forward extra with a trigger level at 1.3800. The company buying the forward extra does not believe that the GBP/USD rate will exceed 1.3800 during the life of the option.
There are three possible scenarios
Unfavourable market moves
GBP/USD weakens. At maturity of the contract the exchange rate is 1.2800. The company is entitled to buy dollars at 1.3200.
Favourable market moves – does not reach the trigger level
GBP/USD strengthens. At maturity, the exchange rate is 1.3600 (but the trigger level of 1.3800 has not been breached during the life of the contract). The company can buy the dollars in the spot market at 1.3600.
Favourable market moves, trading through the trigger level
GBP/USD strengthens, and trades through the trigger level of 1.3800 at any time during the life of the option contract. The company is obliged to buy dollars at 1.3200.
Advantages of the forward extra
- Provides protection on 100% of the company’s exposure
- Allows the company to benefit in full from favourable currency moves up to a pre-determined level
- No premium payable
Disadvantages of the forward extra
- If the trigger level is hit or exceeded at any time during the life of the contract, the company is obligated to deal at the protected rate
- The protected rate will generally be less favourable than the forward rate
- Deposit and/or variation margin may be applicable in line with SCOL terms of business
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