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.
Some Facts
- 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.
ALT21’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.”
