The Participating Forward

For Importers

The participating forward protects clients by providing a worst case rate for their full exposure, like a forward contract. However, it allows clients to 'participate' in any favourable exchange rate move for 50% of their currency exposure. There is no premium payable for a participating forward.

How does a participating forward work?

Let's assume, for example a client imports goods from Japan and she has to pay a supplier 10 million Yen in six months' time.

The forward rate for six months is 60.00. The client would like to give herself a worst case rate but she is worried that if she enters into a forward contract, the rate might move up and she will be unable to benefit from the move. However, she does not want to pay a premium for this. We inform her that she can have a worst case rate of 57.00 but benefit by buying half her Yen at the prevailing spot rate two days before settlement if it is above 57.00.

Possible scenarios:

Scenario 1: AUD/JPY weakens and at maturity the exchange rate is 53.00.

She buys 10 million Yen at 57.00

Scenario 2: AUD/JPY strengthens and at maturity, the exchange rate is 67.00.

She is obliged to buy 5 million Yen at 57.00. However, the remaining 5 million Yen can be purchased in the spot market at 67.00. This will give her an average rate of 62.00

Advantages

Certainty of a worst case rate

The client has 100% protection if the rate moves against her

The client can partially benefit if the rate moves in her favour

Zero premium to pay

Disadvantages

If the rate moves down as in scenario 1, it would have been cheaper to have entered into a forward contract as the worst case rate of 57.00 is not as good as the forward rate of 60.00

If the rate moves up, it would have been cheaper to have not entered into a hedge and bought the Yen in the spot market on the settlement date

The break even spot exchange rate at maturity is 63.00

For Exporters

The participating forward protects clients by providing them with a worst case rate for their full exposure, like a forward contract. However, it allows clients to participate in any favourable exchange rate move for 50% of their currency exposure. There is no premium payable for a participating forward.

How does a participating forward work?

Let's assume, for example, a client exports goods to Japan and forecasts that he will need to repatriate 10 million Yen into Australian dollars in six months' time.

The forward rate for six months is 60.00. The client would like to give himself a worst case rate but he is worried that if he enters into a forward contract, the rate might move down and he will be unable to benefit from the move. However, he does not want to pay a premium for this. We inform him that he can have a worst case rate of 63.00 but benefit by selling half his Yen at the prevailing spot rate two days before settlement if it is below 63.00.

Possible scenarios:

Scenario 1: AUD/JPY strengthens and at maturity the exchange rate is 68.00.

The client sells 10 million Yen at 63.00

Scenario 2: AUD/JPY weakens and at maturity, the exchange rate is 53.00.

The client is obliged to sell 5 million Yen at 63.00. However, the remaining 5 million Yen can be sold in the spot market at 53.00. This will give the client an average rate of 58.00.

Advantages

Certainty of a worst case rate

The client has 100% protection if the rate moves against him

The client can partially benefit if the rate moves with him

Zero premium to pay

Disadvantages

If the rate moves up, it would have been cheaper to have entered into a forward contract

If the rate moves down, it would have been cheaper to have not entered into a hedge and sold the Yen in the spot market on the settlement date

Your break even spot exchange rate at maturity is 57.00

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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