The Convertible Forward

For Importers

The convertible forward enables clients to fix a worst case rate for the currency that they are looking to purchase on a pre-determined date in the future. However, clients can benefit 100% in any favourable move up to a pre-determined best case exchange rate. If the best case rate is hit or exceeded at any time during the life of the trade, clients are obliged to deal at the protected 'worst case' rate. Therefore, this strategy may be suitable for you only if you believe that the spot exchange rate will not hit or exceed the best case rate during the life of the trade.

How does a convertible forward work?

For example, a client imports electronic equipment from China and has to pay his supplier US$1 million in six months' time.

The forward rate for six months is 0.6800. He would like to take advantage of this forward rate but he feels that AUD/USD might continue to push a little higher. Therefore, he accepts a reduction in his protection (worst case) rate down to 0.6500. This enables him to fully benefit from an upwards move up to the best case rate of 0.7800. If the exchange rate of 0.7800 is hit or exceeded at any time before the contract matures, the rate that he achieves reverts back down to 0.6500, regardless of subsequent movements in the spot exchange rate.

Possible scenarios:

Scenario 1: AUD/USD weakens to 0.6000.

On the settlement date, he achieves his worst case rate of 0.6500

Scenario 2: AUD/USD strengthens, and trades at or above 0.7800 at any time during the life of the contract.

He is obliged to buy dollars at 0.6500

Scenario 3: AUD/USD strengthens and at maturity the exchange rate is 0.7300 (0.7800 has not traded during the life of the contract).

He can buy dollars at maturity in the spot market at 0.7300

Advantages

Certainty of a worst case rate

He achieves 100% protection on his exposure

He can benefit from favourable currency moves up to a pre-agreed limit rate (in this instance 0.78)

Zero premium to pay

Disadvantages

If the best case rate is hit or exceeded at any time during the life of the contract, he deals at the worst case rate (in this instance 0.65). In this instance, it would have been better if he had entered into a forward contract or left the exposure unhedged

The protected rate will always be less favourable than the forward rate

For Exporters

The convertible forward enables clients to fix a worst case rate for the currency that they are looking to sell on a pre-determined date in the future. However, they can benefit 100% in any favourable move down to a pre-determined best case exchange rate. If the best case rate is hit or exceeded at any time during the life of the trade, they are obliged to deal at the protected 'worst case' rate. Therefore this strategy may be suitable for you only if you believe that the spot exchange rate will not hit or exceed the best case rate during the life of the trade.

How does a convertible forward work?

For example, a client exports shower curtains to America and she forecasts having to repatriate US$1 million in six months' time.

The forward rate for six months is 0.6800. She would like to take advantage of this forward rate but she feels that AUD/USD might move slightly lower over the next six months. Therefore, she accepts a protection (worst case) rate of 0.7100. This enables the client to benefit from a favourable move in 100% of their exposure down to the best case rate of 0.5800. If the exchange rate of 0.5800 is hit at any time before the contract matures, the rate that the client achieves reverts back up to 0.7100, regardless of subsequent movements in the spot exchange rate.

Possible scenarios:

Scenario 1: AUD/USD strengthens up to 0.7500.

On the settlement date, the client achieves the worst case rate of 0.7100

Scenario 2: AUD/USD weakens, and trades at or below 0.5800 at any time during the life of the contract.

The client is obliged to sell dollars at 0.7100

Scenario 3: AUD/USD weakens and at maturity the exchange rate is 0.6200 (0.5800 has not traded during the life of the contract).

The client can sell dollars at maturity in the spot market at 0.6200

Advantages

Certainty of a worst case rate

The client achieves 100% protection on her exposure

The client can benefit from favourable currency moves down to a pre-agreed limit rate (in this instance 0.5800)

Zero premium to pay

Disadvantages

If the best case rate is hit at any time during the life of the contract, she deals at the worst case rate (in this instance 0.7100). In this instance, it would have been better if she had entered into a forward contract or left the exposure un-hedged.

The worst case rate will always be less favourable than the forward rate

World First Pty Ltd holds an Australian Financial Services Licence - Licence No: 331945 -under the Corporations Act 2001 which authorises it to provide financial services in relation to foreign exchange contracts, derivatives and non cash payments facilities to persons within Australia.

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