Forex Markets

Option Dated Forward Contracts

Many corporates generally prefer option dated forward contracts over fixed date forward contracts. But are they beneficial?

What is option dated forward contract?

Option Dated Forward Contracts – It is the forward contract where the bank gives corporate flexibility to sell/buy underlying (e.g. USD, GBP, EUR) within a specified period.

E.g. – Suppose corporate is expecting USD receivables/payment by end of May 2019. Booking date is 30th Nov 2018. While booking forward contract bank provides corporate a specified period, say 15th May 2019 till 31st May 2019 to execute the booked deal.  

 

Although this flexibility to execute the deal between specified period looks attractive to the corporates as they might not be aware of the actual receivable/payment date of the given underlying, but it’s not.

Let’s see how corporates lose by booking option dated forward contracts

Exporters: –

Let’s consider the above-given example. Corporate is receiving USD by end of May 2019.  Corporate books the contract on 30th Nov 2018 So, the bank gives the option dated contract from 15th May 2019 till 31st May 2019. However, the bank will give a forward premium of the start date of period i.e. 15th May 2019.

 

 

Forward Rate = Spot + Forward Premium (From 2nd Dec 2018 to 15th May 2019)

Case I – Suppose corporate gets receivables between 15th to 31st May 2019, say 25th May 2019. In this case, corporate would have the obligation to sell USD at the forward rate within a specified period. In a way, corporate will be losing 10 days premia from 15th till 25th May 2019.

Case II – Suppose corporate gets receivables on 31st May 2019. In this case, corporate would have the obligation to sell USD at the forward rate. In a way, corporate will be losing 16 days premia from 15th May 2019 till 31st May 2019.


Importers: –

Let’s consider the above given example. Corporate has to pay USD by end of May 2019.  Corporate books the contract on 30th Nov 2018 So, bank gives the option dated contract from 15th May 2019 till 31st May 2019. However, bank will charge forward premium of end date of period i.e. 31st May 2019.

 

Forward Rate = Spot + Forward Premium (From 2nd Dec 2018 to 31st May 2019)

Case I – Suppose corporate has to make USD payment between 15th to 31st May 2019, say 25th May 2019. In this case, corporate would have the obligation to buy USD at the forward rate within a specified period. In a way, corporate will be charged 6 days of more premia from 25th till 31st May 2019 even after executing the deal on 25th May 2019.

 

 Case II – Suppose corporate has to make payment on 15th May 2019. In this case, corporate would have the obligation to buy USD at the forward rate. In a way, corporate will be charged more for 16 days premia from 15th May 2019 till 31st May 2019 even after executing deal on 15th May 2019.

 

 

What is the solution?

Book the fixed dated forward contract 

Forward Rate = Spot + Forward Premium (2nd Dec 2018 to 31st May 2019)

Let’s analyse the benefit of fixed date forward contract.

Exporter: –

Case I – Suppose corporate gets receivables between 15th to 31st May 2019, say 25th May 2019. In this case, corporate would have the obligation to sell USD at the forward rate only on 31st May 2019. However, corporate can early utilise the forward contract on 25th May 2019 without losing 10 days forward premia from 15th May 2019 till 25th May 2019 as in earlier case. While early utilising the forward contract bank will deduct forward premia from 25th May 2019 till 31st May 2019. Also, operational charges like bank margin will not be taken while early utilising the contract.

 

 

 

Case II – Suppose corporate gets receivables on 31st May 2019. In this case, corporate would have the obligation to sell USD at the forward rate only on 31st May 2019. So corporate can save 16 days forward premia as it was forgone in earlier case.

 

 

Importer: –

Case I – Suppose corporate has to make USD payment between 15th to 31st May 2019, say 25th May 2019. In this case, corporate would have the obligation to buy USD at the forward rate only on 31st May 2019. However, corporate can early utilise the forward contract on 25th May 2019 without paying 6 days forward premia from 25th May 2019 till 31st May 2019 as in the earlier case. While early utilising the forward contract bank will deduct forward premia from 25th May 2019 till 31st May 2019 and corporate can buy USD at lesser rate than the earlier case. Also, operational charges like bank margin will not be taken while early utilising the contract.

 

Case II – Suppose corporate has to make USD payment on 15th May 2019. In this case, corporate would have the obligation to buy USD at the forward rate only on 31st May 2019. However, corporate can early utilise the forward contract on 15th May 2019 without paying 16 days forward premia from 15th May 2019 till 31st May 2019 as in earlier case. While early utilising the forward contract bank will deduct forward premia from 15th May 2019 till 31st May 2019 and corporate can buy USD at lesser rate than the earlier case. Also, operational charges like bank margin will not be taken while early utilising the contract.

 

 

 Conclusion: –

Although, option dated forward contracts gives flexibility to execute the deal within specified period, but corporates would lose/pay higher premium for that flexibility. However, though specific date of payment/receivables is not known corporates can always early utilise the fixed dated forward contract without losing or paying higher premium.

By QuantArt 

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