What is Structured Options – Forward with Knock-in Barrier?
A Forward with Knock-In Barrier is a type of Structured option that allows you to lock in a worst-case rate and benefit from movements in the exchange rate up to the Option Knock-In Barrier rate. If the exchange rate touches the Knock-In Barrier rate, you will be required to exchange at the Forward Protection Rate. However, the flexibility around protection up to the Knock-In Barrier remains attractive when compared with a standard Forward.
Key Risks and Benefits
Key Risks of Using a Forward with Knock-In Barrier Include:
- The Forward Protection Rate is usually worse than the comparable standard Forward Rate.
- The Participation is limited at the Knock-In Barrier, and if the barrier is activated, you will be obligated to buy at the Protection Rate, which could be significantly worse off when compared to the prevailing Spot Rate.
Key Benefits of Using a Forward with Knock-In Barrier Include:
- If the Knock-In Barrier is not activated, there is no obligation to deliver the Forward, allowing you to participate in a better Spot Rate with flexibility in cash flow management.
- At any point in time during the contract tenor, the Forward with Knock-In Barrier provides you with risk management certainty as you are always protected.
Key Features Summarized
- Risk Profile: High
- Downside Risk Protection: Yes
- Upside Participation: Yes
- Enhanced Rate on Strike: No
- Allowing Predelivery: Yes
Trading Example
You are an Australian importer of furniture from Malaysia but paying in USD for the goods purchased. With a budgeted cost rate of AUD/USD 0.6800 for the next 6 months, you are worried about the possibility of a sharp drop in AUD/USD in the coming months, but you would also like to participate in favourable market movements. You think the upside movement in AUD/USD will be capped at 0.7700.
Therefore, you can consider using the following Forward with Knock-In Barrier:
- Protection Amount: Buying USD 500,000 against AUD
- Forward Protection Rate: 0.6900
- Knock-In Barrier: 0.7700
- Trigger Window: Live to Expiry
- Expiration Date: 6 months
Structure Details
- Buying an AUD Put/USD Call, strike at 0.6900, Notional USD $500,000; Expiring in 6 months.
- Selling an AUD Call/USD Put, strike at 0.6900, Knock-In Barrier (live) at 0.7700, Notional USD $500,000; Expiring in 6 months.
Outcome at Expiration Date (6 months)
- Outcome 1: If, at expiry, the Knock-In Barrier at 0.7700 has never been touched and the AUD/USD Spot Rate is below the Protection Rate of 0.6900, say at 0.6500, you have the right to buy USD 500,000 at the Protection Rate of 0.6900.
- Outcome 2: If, at expiry, the Knock-In Barrier at 0.7700 has never been touched and the AUD/USD spot rate is above 0.6900, you will not have any obligation and can choose to deal at the more favourable (higher) market spot rate.
- Outcome 3: If, at expiry, the 0.7700 Knock-In Barrier is triggered, you will have an obligation to buy USD 500,000 at the less favourable Protection Rate of 0.6900.
Payoff Diagram
