What is a 'Range Forward Contract'

A range forward contract is a zero-cost forward contract that creates a range of exercise prices through two derivative market positions. A range forward contract is constructed so that it provides protection against adverse exchange rate movements while retaining some upside potential to capitalize on favorable currency fluctuations.

BREAKING DOWN 'Range Forward Contract'

Range forward contracts are most commonly used in the currency markets to hedge against currency market volatility. Range forward contracts are constructed to provide settlement for funds within a range of prices. They require two derivative market positions which creates a range for settlement at a future time.

In a range forward contract, a trader must take a long and short position through two derivative contracts. The combination of costs from the two positions typically nets to zero. Large corporations often use range forward contracts to manage currency risks from international clients.

International Currency Business Risks

Consider for example a U.S. company that has a EUR1 million export order from a European customer. The company is concerned about the possibility of a sudden plunge in the euro (which is trading at 1.30 to the USD) over the next three months when payment is expected. The company can use derivative contracts to hedge this exposure while retaining some upside.

The company would setup a range forward contract to manage the risks of payment from the European client. This could require buying a long contract on the lower bound and selling a short contract on the higher bound. Suppose the lower bound is at EUR1.27 and the higher bound is at EUR1.33. If at expiration the spot exchange rate is EUR1 = US$1.31 then the contract settles at the spot rate (since it is within the 1.27 - 1.33 range). If the exchange rate is outside of the range at expiration then the contracts are utilized. If the exchange rate at expiration is EUR1 = US$1.25, the company would need to exercise its long contract to buy at the floor rate of 1.27. Conversely, if the exchange rate at expiration is EUR1 = US$1.36, the company would need to exercise its short option to sell at the rate of 1.33.

Range forward contracts are beneficial because they require two positions for full risk mitigation. The cost of the long contract typically equates to the cost of the contract to sell, giving the range forward contract a zero net cost.

RELATED TERMS
  1. Buying Forward

    Buying forward is an investment strategy that involves the buying ...
  2. Forward Contract

    A customized contract between two parties to buy or sell an asset ...
  3. Contract Unit

    A Contract Unit is the actual amount of the underlying asset ...
  4. Forward Exchange Contract

    A forward exchange contract is a special type of foreign currency ...
  5. Contract Month

    The contract month is the month in which a futures contract expires.
  6. Forward Market

    A forward market is an over-the-counter marketplace that sets ...
Related Articles
  1. Trading

    How To Lock In An Exchange Rate

    Currency risk can be effectively hedged by locking in an exchange rate through the use of currency futures, forwards, options, or exchange-traded funds.
  2. Investing

    Investing in Crude Oil Futures: The Risks and Rewards

    Learn about the risks and rewards of trading oil futures contracts. Read about a few strategies to limit the risk in trading oil futures contracts.
  3. Trading

    Beginner's Guide To Trading Futures

    An in-depth look into what futures are, and how you can build a solid base to begin trading them.
  4. Financial Advisor

    Divorce and Annuities: What Clients Need to Know

    Divorce can be the most financially devastating event in a person’s life. Here’s what your clients need to know about handling annuities in a divorce case.
  5. Investing

    Fueling Futures In The Energy Market

    The energy market influences every aspect of our lives, and these four options are its driving force.
  6. Investing

    Getting Started In Foreign Exchange Futures

    Learn how these futures are used for hedging and speculating, and how they are different from traditional futures.
  7. Investing

    How To Talk Like An Investor

    Learn the lingo to start talking like an informed investor and make wise investment decisions in financial markets. Find out terms used in stock trading.
  8. Trading

    Combining Forex Spot And Futures Transactions

    The spot, futures and option currency markets can be traded together for maximum downside protection and profit.
RELATED FAQS
  1. What is the difference between derivatives and options?

    A derivative is a financial contract that gets its value from an underlying asset. Options offer one type of common derivative. Read Answer >>
  2. How is the price of a derivative determined?

    Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
  3. How can I calculate the notional value of a futures contract?

    Learn how the notional value of a futures contract is calculated, and how futures are different from stock since they have ... Read Answer >>
Trading Center