A break forward option is a type of currency market tool that allows an investor to lock in a certain exchange rate for a future transaction. It is similar to an option, but it does not require the investor to pay a premium upfront. Instead, the investor pays a break price at the time of entering the contract, which is the maximum exchange rate that the investor can accept for the future transaction. If the spot rate at maturity is higher than the break price, the investor can benefit from the difference and receive more money than what they paid for the contract. However, if the spot rate at maturity is lower than or equal to the break price, the investor will lose money and have to pay more than what they received for the contract.
A break forward option can be used for hedging purposes, such as protecting against unfavorable exchange rate movements or locking in favorable rates for future transactions. For example, suppose an American exporter wants to sell goods to a European buyer in six months and expects that the euro will appreciate against the US dollar in that period. The exporter can enter into a break forward contract with a bank and agree to sell goods worth $100 million at $1.2 per euro in six months. The exporter will pay a break price of $1.15 per euro at that time, which means they will receive $115 million ($100 million x 1.15) if they execute their contract. If six months later, when they enter into their actual transaction, the spot rate is $1.25 per euro, then they will be able to sell their goods for $125 million ($100 million x 1.25) and make a profit of $20 million ($125 million – $115 million). However, if six months later, when they enter into their actual transaction, the spot rate is $1.2 per euro or lower, then they will have to sell their goods for less than $100 million and incur a loss.
A break forward option can also be used for speculative purposes, such as betting on future exchange rate movements or taking advantage of arbitrage opportunities. For example, suppose an investor expects that the British pound will depreciate against the US dollar in three months and decides to enter into a break forward contract with a bank and agree to buy goods worth £50 million at £0.8 per dollar in three months. The investor will pay a break price of £0.75 per dollar at that time, which means they will pay £37.5 million (£50 million x 0.75) if they execute their contract. If three months later, when they enter into their actual transaction, the spot rate is £0.85 per dollar or higher, then they will be able to buy their goods for less than £50 million and make a profit of £12.5 million (£37.5 million – £25 million). However, if three months later, when they enter into their actual transaction, the spot rate is £0.8 per dollar or lower or equal to it , then they will have to buy their goods for more than £50 million and incur a loss.
Basic Theory
A Break Forward Option is a type of financial derivative that combines features of a traditional forward contract and an option contract. It gives the holder the right, but not the obligation, to enter into a forward contract at a predetermined exchange rate on or before a specified future date. This provides a hedge against currency risk, allowing businesses to plan and budget more effectively.
Procedures for Break Forward Options in Excel
Step 1: Setting Up the Excel Sheet
Create a new Excel spreadsheet and organize your data. Include columns for “Start Date,” “End Date,” “Spot Rate,” “Forward Rate,” “Notional Amount,” and “Option Premium.”
Step 2: Calculate Forward Rate
Use the following formula to calculate the Forward Rate:
Forward Rate = Spot Rate * (1 + (Interest Rate Domestic - Interest Rate Foreign) * (Days to Maturity / 360))
Step 3: Determine Option Premium
The option premium is the cost of purchasing the Break Forward Option. This can be determined using various pricing models, such as the Black-Scholes model. For simplicity, let’s assume the premium is 2% of the notional amount.
Option Premium = 2% * Notional Amount
Step 4: Calculate Break Forward Rate
The Break Forward Rate is the sum of the Forward Rate and the Option Premium.
Break Forward Rate = Forward Rate + Option Premium
Scenario
Let’s consider a scenario:
- Start Date: January 1, 2024
- End Date: July 1, 2024
- Spot Rate: 1.2000 USD/EUR
- Notional Amount: $1,000,000
- Interest Rate Domestic: 2%
- Interest Rate Foreign: 1%
Excel Table
| Start Date | End Date | Spot Rate | Forward Rate | Notional Amount | Option Premium | Break Forward Rate |
|---|---|---|---|---|---|---|
| 01/01/2024 | 07/01/2024 | 1.2000 | =B3*(1+(B6-B7)*((B5-B2)/360)) | $1,000,000 | =B4*0.02 | =B4+B8 |
Excel Formulas
- Cell B4 (Forward Rate):
=B3*(1+(B6-B7)*((B5-B2)/360)) - Cell B8 (Option Premium):
=B4*0.02 - Cell B9 (Break Forward Rate):
=B4+B8
Calculation
- Forward Rate:
1.2000 * (1 + (0.02 - 0.01) * ((181-1)/360)) = 1.2060 - Option Premium:
0.02 * $1,000,000 = $20,000 - Break Forward Rate:
1.2060 + $20,000 = 1.2260
Other Approaches
- Sensitivity Analysis: Evaluate how changes in factors like interest rates and time to maturity impact the Break Forward Rate.
- Scenario Analysis: Explore different scenarios to assess the risk and reward associated with Break Forward Options.
- Advanced Pricing Models: Consider using more sophisticated models for option pricing, like the Black-Scholes model, if a higher level of precision is required.
