A participating forward structure provides a secured protected rate, while still allowing beneficial moves on a predetermined portion of the amount hedged. If the spot rate at expiry is more favourable than the protected rate then the holder of the participating forward is only obligated to transact a predetermined proportion of the hedged amount at the protected rate and is free to transact the remainder at the spot rate.
Participating forwards are generally structured as zero-cost premium products.
An example of how a participating forward 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 not 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 the worst-case rate of 1.3200. The company buys a participating forward with a protected rate of 1.3200 and a participation proportion of 50%.
There are two possible scenarios
Unfavourable market moves
GBP/USD weakens. At maturity, the exchange rate is 1.2900. The company is entitled to buy the full $500,000 at 1.3200.
Favourable market moves
GBP/USD strengthens. At maturity, the exchange rate is 1.4200. The company is obligated to buy $250,000 (50%) and the other half can be purchased in the spot market at 1.4200. Due to this strategy the company achieves an effective rate of 1.3700.
Advantages of the participating forward
- Provides protection on 100% of the company’s exposure
- Allows the business to benefit from favourable currency moves on a pre-determined portion of the exposure hedged
- No premium payable
Disadvantages of the participating forward
- The protected rate will always 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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