Complex Swaps Page



Key concepts
Vanilla forwards and forward rate agreements are over-the-counter derivative instruments that lock in a guaranteed price for an underlying asset, such as a foreign exchange rate or an interest rate, for a pre-specified amount at a pre-specified time in the future.
They are typically executed with zero upfront cost and for this reason are preferred by some counterparties, particularly corporate hedgers, to options.
However, zero upfront cost does not mean zero cost.
Because they guarantee a price or rate, forward transactions remove not only the risk that the underlying will move against the holder over the life of the forward, they also remove any potential to benefit from advantageous moves in the underlying.
They therefore trade certainty for potential opportunity costs.
They also remove the ability for a hedger to take views on support/resistance levels or the timing and strength of any market moves.
Options, though they incur an upfront premium, allow the holder both to hedge and to benefit from any upside.
The flexibility of options has led to the development of hybrid combinations of forwards and options to create structured forwards.
These can be tailored to meet a wide variety of client needs and are used both for hedging and for outright view-taking.
The examples on this page illustrate the most important classes of forward and structured forward - but any of these basic templates can be altered with additional strike levels, barriers and reset features.

Cancellation Forward
A standard forward which is automatically cancelled if a predetermined level is breached over the life of the forward.
Typically cancellation forwards enable the client to buy or sell forward at a rate which is better than the forward outright for the same maturity,
at the risk of losing the forward if the cancellation level is touched, in which instance the client will suddenly find his position unhedged.
A client short EUR/USD wants to buy Euros over a six-month horizon.
Spot is 1.0310 and the forward is 1.0378.
The client can buy at 1.0278 as long as the 1.1200 cancellation level is never touched.
Conditional Forward
A structured forward which gives the client the right, but not the obligation, to buy or sell forward on the maturity date of the conditional forward,
providing a pre-determined trigger level is not breached at any time during a pre-specified part of the life of the forward.
If the trigger level is breached then the client will be obliged to buy or sell forward at a rate which is worse than that which would have been incurred if a normal forward outright was executed instead.
Also known as a forward extra.
An investor is short EUR/USD over six months with spot at 1.0310 and the forward at 1.0378. The investor could buy EUR at 1.0400 but this is a right which becomes an obligation only if the trigger level of 1.0100 is ever breached, locking the investor into a rate of 1.0400.
Exchange Rate Agreement (ERA) A type of synthetic agreement for forward exchange (SAFE) settled on the spread between two forward foreign exchange rates instead of with reference to the spot rate.
See non-deliverable forward.

FADING forward
Also known as an accrual forward, this is a synthetic forward where for each period that a pre-determined fixing condition is established, a portion of the contract is locked in.
It provides an opportunity to deal at a rate significantly better than the forward outright rate but only for a portion of the amount corresponding to the frequency that spot has fixed above {below} the trigger level.
The product is an alternative for those with cash flows spread over a period of time or for balance sheet hedgers.
One version is also known as a weekly reset forward.

Forward contract
An agreement to buy or sell a given quantity of a particular asset (such as a currency) at a specified future date at a pre-agreed forward price.
A forward is the over-the-counter equivalent of a future.
The difference between the spot price and the forward price is largely influenced by the cost of carry, that is, for financial assets, interest rates.
For example, for currencies the forward rate for a given future point in time is determined from the interest rate differential between the two currencies.
The theoretical forward price of a carryable asset like a currency contains no expectations of the future spot price since the seller of the contract can hedge by holding the underlying.

An FX swap in which both of the two value dates occur after spot value.
This is simply the forward sale {purchase} of a currency against a forward purchase {sale} with two different dates.

Forward Point Agreement (FPA)
A forward agreement to trade a forward at some point in the future at fixed foreign exchange or interest rate forward points, fixed at the outset of the contract.
An FPA is the FX swap equivalent of an FRA.
The agreements can be cash settled on a net payment basis or physically settled by entering into the forward at the fixed points directly on the FPA maturity date.
The FPA contract enables users to separate the timing of the spot exchange rate and forward points used in a forward foreign exchange contract by fixing the level of forward points used in a forward foreign exchange rate and leaving the spot exchange rate to be determined at any time up to the forward exchange date.
These are much less frequently used than forward-forwards.

Forward Rate Agreement (FRA)
An interest rate contract in which buyer and seller agree to exchange the difference between the current interest rate and a pre-agreed fixed rate,
struck on the date of execution of the FRA contract.
If rates have risen, then at maturity the purchaser of the FRA receives the difference in rates from the seller.
If they have fallen, the seller receives the difference from the buyer.
The buyer of an FRA fixes a future borrowing cost; the seller fixes the rate of return on a future deposit.

FRA prices are quoted as interest rates on the basis of the bid and offer yield levels for the period of the FRA.
The FRA rate itself is the implied forward rate for the relevant date.
FRAs are labelled on the basis of the number of months to the start and end of the FRA.
So a three-month FRA starting one-month forward is a 1 x 4 FRA or 1 v 4 FRA and a 3 v 9 FRA is trading the implied six-month rate in three months' time.
So if the 3 v 9 were trading at 6.90% and a hedger or speculator believed that in three months' time six-month Libor would be above 6.90%, then they would buy the FRA on their desired notional principal.
Unlike interest rate futures, there are no up-front margin payments.
FRAs are the building blocks from which swaps are constructed.
See forward-forward [interest] rate, implied forward.
Knock-in cancellation forward
A structured forward transaction which is automatically cancelled if a predetermined cancellation level is breached over the life of the forward.
In addition the holder of the position incurs no downside liability providing that spot has failed to breach a preset knock-in level over the life of the forward.
This is effectively a combination of the cancellation forward and knock-in forward strategies described above.
Long-term foreign exchange (LTFX)
The outright forward purchase or sale of a currency for a future date at a price agreed at the inception of the agreement with no spot exchange at the time of closing.
They enable the holder to lock away forward foreign exchange points for periods over 18 months and are used primarily to hedge existing or anticipated exposures such as long-term borrowings or future receivables.
LTFX agreements usually entail a single exchange at a future date or a series of exchanges spread evenly over a number of years.
Equivalent to zero-coupon currency swaps they can be used to replicate fixed-to-fixed currency swaps.
Non-deliverable forward (NDF)
A form of synthetic agreement for forward foreign exchange (SAFE) whose value at maturity is based on the difference between the forward rate on the start date and the spot rate at settlement and may be settled with a different asset from those that related to the forward.
Generally used as a forward when one of the two currencies is not freely convertible for net value and so which is cash-settled in the freely convertible currency.
Also known as a forward exchange rate agreement or FXA.

Out-performance forward
The name given to a wide range of structures whose central aim is to construct a synthetic forward using barrier options, which give the holder the potential to out-perform the forward outright if his market view, around which the out-performance forward is tailored, is correct.
These are constructed from any combination of knock-in or knock-out options.
Variations include barrier windows and strips of out-performance forwards to cover a series of foreign exchange transactions.

Participating forward
An adaptation of the range forward in which fewer options must be sold than are purchased.
Also known as profit-sharing forwards they are a type of ratio forward and are usually structured to be zero premium.
So in-the-money put {call} options are sold to finance the purchase of out-of-the-money call {put} options.
In the FX version of the trade the holder might have a long call position twice as large as the short put.
This gives the holder participation in 50% of the weakening of the underlying currency whilst retaining full protection on the upside if used as a hedge for an underlying short position.

Prepaid forward sale
The sale of the underlying for the future with the present value of the forward sale paid to the seller at the outset of the transaction.
This is common as a loan substitute in the commodities markets.
Oil producers sell oil on a prepaid basis to a lender/counterparty who pays the producer and then hedges his forward oil price risk through the sale of physical crude or using a commodity swap.
Producers use such transactions because it enables them to pay off debt today with tomorrow's revenue.
In other markets also known as an off-market forward.

Range forward
The combination of an anticipated position in the underlying such as a foreign currency receivables payment in three months time with a risk reversal.
Unlike a standard forward, which locks in a fixed exchange rate for a forward exchange of currencies effectively the buyer pays away all upside potential to the seller in exchange for an equivalent payment if rates move the other way the range forward gives the holder exposure to spot rates but only within the range set by the short put and long call position.
These floor the downside risk at the cost of capping the potential upside.
The range forward is usually structured so that no premium is payable upfront.
This is the name given by currency markets to what in the interest rate markets is called a collar (the interest version entails the purchase of a cap and sale of a floor).
The position is also called a cylinder.

A EU based company will receive USD 100 million in 3 months.
It wants to hedge against USD depreciation while maintaining some exposure to USD appreciation against the EUR but does not want to pay the upfront premium associated with a naked USD put/EUR call option.
Nor does he want to lock in the forward rate because he is hopeful that the USD will move in his favour.
He chooses to purchases a EUR call/USD put struck at 1.0475 and sells a EUR call/USD put at 1.0275.
The forward is at 1.0377 and so the range forward has zero upfront premium.
If the USD depreciates beyond 1.0475, then the company exercises its put at 1.0475 and fixes a minimum value of EUR 94.56 million for its USD 100 million receivables.
If spot remains between the two option strikes then both expire worthless and the USD position is exchanged at the spot rate.
If the USD appreciates beyond 1.0275 and the holder of the sold call option will exercise it, capping the maximum value of the USD 100 million at EUR 97.32 million.
The three diagrams opposite represent the same transaction.
Strictly speaking the third shows only the pay-off from the option position which without the underlying short forward position is a risk reversal.
However it is often used to represent a range forward and risk reversal and range forward are sometimes used interchangeably.

[Range] bonus forward
A forward transaction struck at a rate that is better than the forward outright the bonus forward rate.
If spot ever trades outside a pre-specified range around the initial spot rate at any time over a pre-specified period over the life of the forward, then the bonus forward resets to a rate which is worse than the forward outright the reset forward rate.
So an investor who could sell EUR against USD in three months at 1.0377 could instead execute a range bonus forward where the bonus rate of 1.0577 is achieved if EUR/USD trades inside a 1.0000 to 1.0950 range and the reset range of 1.0277 if not.

Ratio forward
In general any position similar to the range forward but where the call and put positions are unequal.
Often used specifically of a strategy in which the long call position is combined with a short put position with a larger notional amount.
This enables both a more conservative strike on the put and a more aggressive strike on the call.
It is a bullish strategy with stronger views that spot will not go below the put strike.
See participating forward.

Rebate forward
A forward in which the buyer enters into a structured forward transaction which is automatically cancelled or knocks out if a predetermined trigger level is breached over its life.
However, unlike the standard cancellation forward, the client will permanently lock in a rebate should the forward be cancelled.
Synthetic Agreement for Forward Exchange (SAFE)
The generic term for exchange rate agreements (ERAs) and non-deliverable forwards (NDFs also known as forward exchange agreements or FXAs).
While forwards involve the actual sale and purchase of the underlying, SAFEs are notional principal contracts like FRAs and are cash settled, NDFs with reference to both the spot rate and forward premium/discounts, ERAs with reference only to the latter.
They were created to overcome capital adequacy requirements which constrained banks in the forward market rather than as a result of demand for an alternative to forwards.
They are now used as a substitute for forwards in markets where currencies are not freely or easily convertible.

Synthetic forward
The combination of a long European-style call and short European-style put or vice versa with the same expiration and at-the-money-forward strike prices.
A long forward position is a long call position combined with a short put position.
A short forward position is a long put position combined with a short call position.
The volatility used for both must be the same to avoid conversion arbitrage (see chapter 8), reflecting put-call parity.

Trigger Forward
The combination of a standard forward and a short knock-out option position.
The holder can enter into a forward to buy or sell at a rate which is better than the forward outright, but is exposed to the risk that if spot hits a predetermined trigger level the structure knocks out.
However, this risk is less than is the case with a cancellation forward, as the client's protective put or call is transformed into a put or call spread rather than being totally cancelled out.
For example, in order to hedge a long position the client would buy a put and sell a call to create a synthetic forward,
and simultaneously sell a put struck below the put that is being purchased,
that is only activated if spot trades below a pre-specified level at any time during a pre-specified period of the life of the position.
More structured variants of this strategy exist which attach an out-of-the-money knock-out on the put or call spread that the client is purchasing and a knock-in feature on the call or put that the client is selling.
Trigger forwards which use more than one option are known as double trigger forwards.