Market and hedging conditions
For illustration purposes, the strategies presented in this document follow these assumptions:
- Currency pair is GBP/USD
- You are going to buy USD 500,000
- You need hedging for a tenor of 180 days
- Reference spot rate is at 1.2450
- Reference forward rate is at 1.2508
Strategy Summary
| Product | Upfront Cost | Protected Rate | Upside Limit | Leverage |
|---|---|---|---|---|
| Outright Forward | — | 1.2508 | — | — |
| Vanilla Option | GBP 12,000 | 1.2450 | Infinite | — |
| Forward Extra | — | 1.2260 | 1.3075 | — |
| Ratio Forward Extra | — | 1.2590 | 1.3075 | 200% |
| Knockout Forward Extra | — | 1.2490* | 1.3075 | — |
| Spread Forward Extra | — | 1.2430** | 1.3075 | — |
* You can buy or sell currency at the Protected Rate for as long as the spot market rate does not trade at or beyond a pre-agreed Knockout Rate 1.1200, at which point the contact will immediately terminate.
** If the spot rate is below 1.1825 on expiry, you will receive a reduced rate
Outright Forward
Description
An Outright Forward contract is the straightforward currency hedging tool. It allows you to buy your currency requirement at a rate determined today, whilst delaying the settlement of the contract until a future date.
By entering into an Outright Forward contract you have removed the uncertainty of exchange rate movement. In exchange for the transaction rate certainty, you have lost the opportunity to take advantage of any favourable exchange rate movements between the trade date and the value date.
Advantages
- Provides you with full protection against a depreciation of the spot rate below the Protected Rate
- No premium payable / Zero cost
Disadvantages
- You are unable to benefit from an appreciation of the spot rate above the Protected Rate
- You may be Margin Called
How it works
You import goods from the US and need to pay USD 500,000 in 6 months’ time to your supplier.
The prevailing spot rate for GBP/USD is 1.2450, the half year forward rate is 1.2508. You do not want to benefit from favourable market moves. You accept a Protected Rate of 1.2508.
If at expiry, the spot rate is below the Protected Rate then you receive the Protected Rate on 100% of the agreed exposure. If, however, the spot rate is above the Protected Rate, you are obliged to transact at that Protected Rate, although it is worse the prevailing spot market rate.
Graphical Overview
Possible outcomes at expiry
GBP/USD weakens and, on the expiry date, the spot rate is 1.2050. This is below the Protected Rate. You buy USD 500,000 from us at the Protected Rate of 1.2508.
GBP/USD strengthens and at expiry the market rate is 1.2925. This is above the Protected Rate. Nevertheless you are obliged to buy USD 500,000 from us at the Protected Rate.
Vanilla Option
Description
A Vanilla Option is a standardised financial instrument that gives the holder the right, but not the obligation, to buy or sell and underlying currency at a predetermined price on a given expiry date.
Hence, this product gives you a worst case rate for your future currency transaction, whilst at the same time allowing you to benefit from any favourable upward movement in the spot market.
There is an upfront Premium payable for this product.
Advantages
- Provides you with full protection against a depreciation of the spot rate below the Protected Rate
- Enables you to fully participate in favourable spot market moves
- Your possible loss is limited by the option Premium, and you will never be Margin Called
Disadvantages
- You pay the option Premium upfront
How it works
You import goods from the US and need to pay USD 500,000 in 6 months’ time to your supplier.
You buy a Vanilla Option that provides protection at 1.2450 (known as the “Protected Rate”). You pay a premium upfront GBP 12,000 (in this example). You will never have to pay an additional margin call for the transaction. On the maturity date of the deal (i.e. in six months time), if the rate in the market is more favourable than the Protected Rate 1.2450, you can simply deal at spot at the more favourable rate.
Graphical Overview
Possible outcomes at expiry
GBP/USD weakens and, on the expiry date, the spot rate is 1.2000. This is below the Protected Rate. You have the right but are not obliged to buy USD 500,000 from us at the Protected Rate of 1.2450.
GBP/USD strengthens and at expiry the market rate is 1.2900. This is above the Protected Rate and you may buy any amount of currency in the spot market at the prevailing market rate.
Forward Extra
Description
A Forward Extra provides you with a guaranteed Protected Rate, whilst allowing you to fully participate in favourable exchange rate movements as far as a pre-determined Barrier Rate.
If the spot rate breaches this pre-determined Barrier Rate at any time during the life of the contract, you will be obliged to transact the Notional Amount at the Protected Rate, regardless of where the spot rate is on the expiry of the option.
Advantages
- Provides you with guaranteed hedge against a depreciation of the spot rate below the Protected Rate
- You are able to participate in an appreciation of the spot rate above the Protected Rate
- No premium payable / Zero cost
Disadvantages
- Your hedged rate is lower than the prevailing market forward rate
- If the spot rate hits the Barrier Rate at any time, you have to transact at the Protected Rate
- You may be Margin Called
How it works
You import goods from the US and need to pay a supplier USD 500,000 in 6 months’ time.
The prevailing spot rate for GBP/USD is 1.2450, the half year forward rate is 1.2508. You would like to benefit from favourable market moves but are reluctant to pay a premium for this. You are prepared to accept a hedging Protected Rate of 1.2260. We then calculate the Barrier Rate to be 1.3075 (in this example). This ensures that you are protected at 1.2260 with the ability to participate in favourable market movements up to the Barrier Rate of 1.3075.
Graphical Overview
Possible outcomes at expiry
GBP/USD weakens and, on the expiry date, the spot rate is 1.1925. This is below the Protected Rate. You have the right but are not obliged to buy USD 500,000 from us at the Protected Rate of 1.2260.
GBP/USD strengthens and at expiry the market rate is 1.2675, having never traded at or above the Barrier Rate of 1.3075. This is above the Protected Rate and you may buy any amount of currency in the spot market at the prevailing market rate.
GBP/USD strengthens and at expiry the market rate is 1.2975, hitting the barrier at 1.3075. You are obliged to buy USD 500,000 from us at the Protected Rate of 1.2260.
Ratio Forward Extra
Description
A Ratio Forward Extra provides you with an enhanced Protected Rate that is better or very close to the prevailing forward rate, whilst allowing you to fully participate in favourable exchange rate movements as far as a pre-determined Barrier Rate.
Upon expiry If the prevailing spot rate is above the Protected Rate and the spot rate breaches the pre-determined Barrier Rate at any time during the life of the contract you will be obliged to transact the Ratio Amount at the Protected Rate.
Advantages
- The enhanced rate provides protection at better levels relative to the market forward rate at the time of entering into the contract
- You are able to benefit from an appreciation of the spot rate above the Protected Rate
- No premium payable / Zero cost
Disadvantages
- If the spot rate hits the Barrier Rate at any time, you have to transact at the Protected Rate
- Upon expiry you may be obliged to transact the ratio amount, if the spot rate hits the Barrier Rate at any time during the life of the contract
- You may be Margin Called
How it works
You import goods from the US and need to pay a supplier USD 500,000 in 6 months’ time.
The prevailing spot rate for GBP/USD is 1.2450, the half year forward rate is 1.2508. You would like to benefit from favourable market moves but are reluctant to pay a premium for this. You are prepared to accept a hedging Protected Rate of 1.2590 and possible increase in the transaction amount to USD 1,000,000. We then calculate the Barrier Rate to be 1.3075 (in this example). This ensures that you are protected at 1.2590 with the ability to participate in favourable market movements up to the Barrier Rate of 1.3075.
Graphical Overview
Possible outcomes at expiry
GBP/USD weakens and, on the expiry date, the spot rate is 1.2075. This is below the Protected Rate. You have the right but are not obliged to buy USD 500,000 from us at the Protected Rate of 1.2590.
GBP/USD strengthens and at expiry the market rate is 1.2825, having never traded at or above the Barrier Rate of 1.3075. This is above the Protected Rate and you may buy any amount of currency in the spot market at the prevailing market rate.
GBP/USD strengthens and at expiry the market rate is 1.3025, hitting the barrier at 1.3075. You are obliged to buy the ratio amount USD 1,000,000 from us at the Protected Rate of 1.2590.
Knockout Forward Extra
Description
A Knockout Forward Extra provides you with a Protected Rate very close to the prevailing forward rate, whilst allowing you to fully participate in favourable exchange rate movements as far as a pre-determined Barrier Rate. If the spot rate breaches this pre-determined Barrier Rate at any time during the life of the contract, you are obliged to transact the Notional Amount at the Protected Rate, regardless of where the spot rate is on the expiry of the option.
Additionally, if the market moves against you, there is a Knockout Rate, at which point the contact will immediately terminate. if the spot rate breaches a pre-determined Knockout Rate at any time during the life of the contract, the product ceases to exist and there are no obligations on either party.
Advantages
- You are protected at a better rate relative to the current market at the time of entering into the contractas as long as the spot market rate remains above the Knockout Rate for the duration of the contract
- You are able to participate in an appreciation of the spot rate above the Protected Rate
- No premium payable / Zero cost
Disadvantages
- If the spot rate hits the Barrier Rate at any time, you will no longer be able to participate in favorable market movements
- If the spot rate breaches the Knockout Rate at any time during the life of the contract, the product will immediately terminate
- You may be Margin Called
How it works
You import goods from the US and need to pay a supplier USD 500,000 in 6 months’ time.
The prevailing spot rate for GBP/USD is 1.2450, the half year forward rate is 1.2508. You would like to benefit from favourable market moves but are reluctant to pay a premium for this. We have informed you that we can offer an Protected Rate of 1.2490 with the ability to participate in favourable market movements up to the Barrier Rate of 1.3075, as long as the Knockout Rate of 1.1200 is never reached during the life of the contract, at which point the contract is terminated.
Graphical Overview
Possible outcomes at expiry
GBP/USD weakens and, on the expiry date, the spot rate is 1.1850, having never traded at or below the Knockout Rate of 1.1200. You have the right but are not obliged to buy USD 500,000 from us at the Protected Rate of 1.2490.
GBP/USD strengthens and at expiry the market rate is 1.2775, having never traded at or above the Barrier Rate of 1.3075. This is above the Protected Rate and you may buy any amount of currency in the spot market at the prevailing market rate.
GBP/USD strengthens and at expiry the market rate is 1.3000, hitting the barrier at 1.3075. You are obliged to buy USD 500,000 from us at the protected Rate of 1.2490.
GBP/USD weakens to 1.1200 breaching the Knockout Rate of 1.1200. The contract is terminated at that point, leaving no delivery in place.
Spread Forward Extra
Description
A spread forward extra provides you with a protected rate very close to the prevailing forward rate, whilst allowing you to fully participate in favourable exchange rate movements as far as a pre-determined barrier rate. If the spot rate breaches this pre-determined barrier rate at any time during the life of the contract, you are obliged to transact the notional amount at the protected rate, regardless of where the spot rate is on the expiry of the option.
Additionally, if the market moves against you, there is a reduction rate that caps your transaction level. If spot is beyond this reduction rate on the expiry date, your transaction rate will be adjusted so that you obtain a spot level that is boosted by the difference between the Protected rate and the reduction rate.
Advantages
- Provides you with some protection against a depreciation of the spot rate below the Protected Rate
- You are able to participate in an appreciation of the spot rate above the Protected Rate
- No premium payable / Zero cost
Disadvantages
- If the spot rate hits the Barrier Rate at any time, you will no longer be able to participate in favorable market movements
- If the spot rate is below the Reduction Rate on expiry you will receive a reduced rate
- You may be Margin Called
How it works
You import goods from the US and need to pay a supplier USD 500,000 in 6 months’ time.
The prevailing spot rate for GBP/USD is 1.2450, the half year forward rate is 1.2508. You would like to benefit from favourable market moves but are reluctant to pay a premium for this. You are prepared to accept a Protected Rate of 1.2430 and a Reduction Rate 1.1825. We then calculate the Barrier Rate to be 1.3075 (in this example). This ensures that you are protected at 1.2430 down to 1.1825 with the ability to participate in favourable market movements up to the Barrier Rate of 1.3075. Upon expiry if the spot rate is below the Reduction Rate, your transaction rate will be improved by 605 basis points from the prevailing spot rate.
Graphical Overview
Possible outcomes at expiry
GBP/USD weakens and, on the expiry date, the spot rate is 1.2125. This is below the Protected Rate but is above the Reduction Rate. You have the right but are not obliged to buy USD 500,000 from us at the Protected Rate of 1.2430.
GBP/USD weakens and, on the expiry date, the spot rate is 1.1700. This is below the Reduction Rate. You are obliged to buy USD 500,000 from us at the spot rate boosted by 605 basis points. Your hedged rate is 1.2305.
GBP/USD strengthens and at expiry the market rate is 1.2750, having never traded at or above the Barrier Rate of 1.3075. This is above the Protected Rate and you may buy any amount of currency in the spot market at the prevailing market rate.
GBP/USD strengthens and at expiry the market rate is 1.3000, hitting the barrier at 1.3075. You are obliged to buy USD 500,000 from us at the protected Rate of 1.2430.
Contact us
If you have any questions or would like any additional information please contact one of our currency risk specialists
+44 (0)207 740 000
Currency Solutions Limited, 2 Jacob Street, London SE1 2BG
Disclaimer and Important Information
This presentation has been prepared on behalf of Currency Solutions Limited for the information of its potential clients. It is not investment advice or an offer or solicitation for the purchase or sale of any financial instrument.
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