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.
Range Forward Contract Explained
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 set up 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.