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A participating forward is a Hybrid FX Forward and Option instrument.
The amount you want to protect — or hedge — is split into two parts.
One part works like a standard forward contract. In other words, you enter a legal obligation to exchange a specified amount of foreign currency on a certain date at a specified rate.
The second part works like a standard financial option instrument. That is, you have the right — but not the obligation — to exchange a specified amount of foreign currency on a certain date at a specified rate.
The split is up to you. You could go 50:50 — 50% forward and 50% option — or 60:40, or even some other ratio that makes more sense to you.
That said, there will be one exchange rate that covers the whole contract. This is known as the ‘worst-case rate’.
Unlike standard options, participating forwards don’t require you to pay a premium to secure your worst-case rate.
You’re also only legally obliged to complete the forward part of the transaction. So if the market exchange rate is better than the ‘worst-case rate’, you can still benefit from it.
The flipside is that, because forward contracts create a legal obligation, you’ll always have to exchange part of the money at the worst-case rate, so there’s a limit to how much you can benefit from a favourable exchange rate.
The worst-case rate is also less favourable than the rate you’d get if you went for a standard forward contract. The worse rate makes up for the fact that you’re not paying a premium for the option.
- Participating forwards get their name because they allow you to take advantage of — or ‘participate’ in — favourable market movements. The way in which your transaction is split between forward and option is called the ‘participating ratio’.
- Because participating forwards are designed to cover your entire exposure, it’s hard to sell or transfer them to somebody else. This makes them unsuitable for speculative traders
- You can end a participating forward before its maturity date, but this will usually entail paying a hefty termination fee.
Want to know more?
- This video sums up what participating forwards are and how they work in under 2 minutes.
- Participating forwards are a type of ‘structured option’ — a complex option created by combining two or more basic, or ‘vanilla’ options. This white paper explains the basics of several types of structured options — not just participating forwards, but also knock-in forwards, convertible forwards, and ratio forwards.
Assure Hedge’s perspective:
“If you want to protect your business from exchange rate fluctuations, but aren’t keen on paying a premium or entering into a legally binding contract, participating forwards can offer you the best of both worlds. You can hedge 100% of your exposure, but still take advantage if the forex markets go your way.”
High Risk Investment Notice
Trading in leveraged financial instruments such as Options or other financial derivatives, carries a high level of risk and may not be suitable for all investors. Investors who make use of these financial products run the risk of substantial capital losses which may exceed your initial deposit. Assure Hedge (UK) Limited makes no claim or warranty regarding either the appropriateness or suitability of these instruments for your purposes whether commercial or otherwise. Assure Hedge (UK) Limited may provide general commentary or educational material available on its website or otherwise, which is not intended as investment advice. You should carefully consider your financial situation and needs and seek independent advice from a duly authorised financial adviser. Assure Hedge (UK) Limited assumes no liability for errors, inaccuracies or omissions; does not warrant the accuracy, completeness of information, text, graphics, links or other items contained within these materials. You should read and understand Assure Hedge (UK) Limited’s Terms and Conditions prior to taking any further action.
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DISCOVER OTHER CONCEPTS IN OUR CURRENCY HEDGING GLOSSARY
Mark-to-market is the accounting process that measures the real-world value of foreign exchange trades. It shows whether you’ve made a profit or a loss on a trade and whether your broker should credit your trading account or make a margin call.
A non-deliverable forward is a forward contract which is settled in your local currency. Like standard forward contracts, non-deliverable forwards are agreements to buy or sell X amount of a certain currency at a predetermined exchange rate on X date in the future.
Out of the money
'Out of the money' is one of three terms used to describe an option's value, or 'moneyness'. The other two terms are 'at the money' and 'in the money'. When an option is out of the money, its strike price — that is, the price at which you'd exercise the option — is lower than the market price.