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Note: In today's economic environment, multi-national companies face uncertainties over their foreign revenues and foreign currency cash flows.
In today's economic environment, multi-national companies face uncertainties over their foreign revenues and foreign currency cash flows. As it is becoming more difficult to project the exact amount and timing of such cash flows, it is also more challenging to hedge foreign currency exposure using traditional forward contracts, which require specification of the exact amount and maturity at the time of trade. As a result, flexible forwards have become a popular hedging alternative for companies who need to hedge their FX exposure with more flexibility.
Like a traditional forward, the rate, total amount and maturity of a flexible forward are specified at the time of trade. Therefore, it is considered effective in hedging the underlying exposure and it can qualify for hedge accounting. In addition, a flexible forward allows the company to partially exercise the forward before maturity, up to the total amount. This partial exercise can be done according to the company's needs and discretion, within some specified limits. Any amount not exercised before maturity needs to be settled at maturity. In return for this benefit, the cost of a flexible forward will be somewhat higher than that of a traditional forward.
We will explore some practical examples of flexible forwards to understand how the product can be used to meet a company's business needs. We will also provide some insights into the effects of an exercise period and the forward curve on pricing.
1. Fixed Rate And Open Exercise Period
Company buys USD/JPY
Maturity Date: 1 year
Notional: USD 10,000,000
Flexible Forward Price: 92.55
Exercise Period: from trade date to maturity
Exercise Amount: multiples of USD 50,000
Spot Reference: 92.50
Forward Reference: 92.00
First let us look at a flexible forward with a fixed rate and open exercise period. The forward rate is fixed at the time of trade, and the user can partially exercise the forward during the open period from trade date to maturity.
The following are sample terms of this type of flexible forward for a company who needs to buy the U.S. dollar (USD) against the Japanese yen (JPY):
We can assume that the company forecasts its need to buy...