Hedging currency risk with a Forward Extra currency contract

Guaranteed currency protection with the potential for extra income

Businesses that trade internationally often choose forward contracts to hedge the risk of unfavourable currency exchange rates in the time period from invoice to settlement of the transaction, which could be months in future.

Though very simple and effective, forward contracts are inflexible because they do not allow businesses to benefit if the exchange rate moves in their favour.

The Forward Extra currency contract is an innovation that overcomes the inflexibility of conventional forward contracts.

In essence, for accepting a slightly worse forward rate than the market forward rate on a conventional forward contract, the business gets the opportunity to earn 100% of any favourable movement in the exchange rate up to the expiry date of the Forward Extra contract. 

In addition to the slightly worse forward rate, the business accepts that it will get 0% of any favourable movement in the exchange rate up to the expiry date of the Forward Extra contract, if the favourable exchange rate movement exceeds a knock-out trigger level at any time up to the settlement date or (for a European-style Forward Extra) on the expiry date of the Forward Extra contract.

For example, suppose a business is due to pay a $ invoice in 3 months.  It has to exchange its £ for at least £1:$1.50  The 3 month forward is £1:$1.52
It enters into a 3-month Forward Extra with a forward rate of $1.50 and a knock-out trigger rate of $1.55 that may be triggered at anytime (an American-style option).

If on the expiry date the spot rate is $1.48, it will receive $1.50
If on expiry the spot rate is between $1.50 and $1.55, it will receive the spot rate
If at any time up to the expiry date the rate is at $1.55 or above that (e.g $1.60), then it will convert on the expiry date at $1.50 forward rate.

The Forward Extra works best if the business's forecast of the maximum level of the future exchange rate is accurate, because if, in this example, the $ depreciates more than forecast (more than $1.55) the business gets none of the benefit of the depreciation up to $1.55 

While it loses the upside it is guaranteed protection in case the $ appreciates below $1.50

To discuss your currency risks or currency transfers, contact me now, without obligation or charge.