A Leveraged Forward is a structured option that uses leverage to improve your Protection Rate when compared to a standard Forward contract. This means at expiry if the Protection Rate is worse than the Spot Rate then you are obligated to settle on a leveraged amount which might occur a larger Out-of-the-Money (OTM) position. The leveraged amount should be seen as the full obligation amount but not the Protection Amount. This potentially would leave the corporate under-hedged. However, if you are relying on the Protection Amount to calculate the cashflow projections from the Leveraged Forward, it could result in an over-hedging situation should the currency pair move against the trade.
Key Risks of Using a Leveraged Forward Include
- On the Expiration Date, if the Spot Rate is better than the Protection Rate, you will be obligated to buy the leveraged amount at a worse off rate. Before the Expiration Date and Settlement, the leveraged obligated amount might incur a large Out-of-the-Money (OTM) position which could result in you being margin called by CAFX.
- Prior to expiry, there is always uncertainty of the Settlement amount at the Expiration Date; subsequently, it is very hard to project the cashflow requirements.
- No upside participation from the Protection Rate.
Key Benefits of Using a Leveraged Forward Include
- The Protection Rate is at an enhanced rate which is more favourable than the comparable Forward Rate available in the market.
- A Leveraged Forward provides risk protection on the Protection Amount at any time before the expiry.
- Leveraged Forward also allows you to pre-deliver your protection amount anytime, which works similar to a normal Forward Drawdown.
Key Features Summarized
- Risk Profile: High
- Downside Risk Protection: Yes
- Upside Participation: No
- Enhanced Rate on Strike: Yes
- Allowing Predelivery: Yes
Trading Example
Assuming that you are an Australian importer buying goods from the U.S. and need to pay USD $600,000 as an aggregated amount within the next 6 months. Although the Spot Rate is currently at 0.7100, you would like to achieve an AUD/USD Protection Rate of 0.7200. You cannot achieve this objective with a standard Forward as the current Forward Rate is 0.7080. You are not concerned with potentially having to settle the Leveraged Amount of USD $1,200,000 as you have other imports from China which also require USD payments that are currently unhedged.
Therefore, you consider the following Leveraged Option:
- Protection Amount: buying USD 600,000 against AUD
- Leveraged Amount: buying USD 1,200,000 against AUD
- Protection Rate: 0.7200
- Expiration Date: 6 months
Structure Details:
- Buying an AUD Put/USD Call, strike at 0.7200, Notional USD $600,000, expiring in 6 months.
- Selling an AUD Call/USD Put, strike at 0.7200, Notional USD $1,200,000, expiring in 6 months.
Outcome at Expiration Date (6 months):
- Outcome 1: At the Expiration Date, if the Spot Rate finishes above the Protection Rate, say at 0.7500, the client will be obligated to buy the Leveraged Amount of USD $1,200,000 at 0.7200;
- Outcome 2: At the Expiration Date, if the Spot Rate finishes below the Protection Rate, say at 0.6800, the client can buy the Protection Amount of USD $600,000 at the enhanced rate of 0.7200.
Payoff Diagram:
