Forward Extra

Secured Protection Rate

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.

1. Requirements

The company: 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 1.3300

3. Solution

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

Scenario 1:

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.

Scenario 2:

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.

Scenario 3:

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.