A Participating Forward is a type of structured option that allows you to set a Forward Protection Rate. This option enables you to benefit from favorable exchange rate movements by allowing you to trade a pre-agreed percentage of your contract value at a more favorable Spot Rate. At the same time, it hedges 100% of your contract value in case the exchange rate moves in an unfavorable direction.
Key Risks of Using a Participating Forward
- The Forward Protection Rate may be less favorable than a comparable forward exchange rate.
- If the Spot Rate on the expiration date is better than the Forward Protection Rate, your ability to benefit from the more favorable rate is limited to the predetermined Participating Amount.
Key Benefits of Using a Participating Forward
- If the Spot Rate on the expiration date moves in your favor, the Participating Forward allows you to benefit from the favorable exchange rate for the predetermined Participating Amount. This could result in a better average exchange rate than your original Forward Protection Rate.
- The Participating Forward provides protection for 100% of your exposure (the Forward Amount).
Key Features Summarized
- Risk Profile: Low
- Downside Risk Protection: Yes
- Upside Participation: Yes
- Enhanced Rate on Strike: No
- Allowing Pre-delivery: Yes
Trading Example
An Australian importer (you) has agreed to purchase goods from China in USD; however, payment is not to occur for 3 months from now. Your budget cost rate for AUD/USD is at 0.7000, while the current spot rate is 0.7150.
If the spot rate is above your budgeted rate, you can consider using the following Participating Forward:
- Forward Amount: Purchase of USD $1,000,000 against AUD
- Participation Amount: USD $500,000 against AUD
- Forward Protection Rate: 0.7000
- Expiration Date: 3 months
Structure Details:
- Buying an AUD Put/USD Call, Strike at 0.7000, Notional USD $1,000,000; expiring in 3 months.
- Selling an AUD Call/USD Put, Strike at 0.7000, Notional USD $500,000; expiring in 3 months.
Outcome at Expiration Date (3 months from now):
Outcome 1: If the Spot Rate is above 0.7000, for example 0.7500 (i.e., AUD has appreciated), instead of buying the USD $1,000,000 Forward Amount at 0.7000, you are only obligated to buy USD $500,000 at 0.7000, and you can choose to buy the other USD $500,000 at the Spot Rate of 0.7500, which is a much better rate. This will result in an approximate average exchange rate of 0.7250, exceeding your desired Protection Rate of 0.7000.
Outcome 2: If the Spot Rate falls below 0.7000 (i.e., AUD has depreciated) to 0.6650, you will be protected for 100% of your exposure at 0.7000 as the Forward Amount is USD $1,000,000 at the Forward Protection Rate of 0.7000.
Payoff Diagram:
