PAR FORWARD
DESCRIPTION
A Par Forward is an agreement to exchange a series of cashflows over time in one currency for a series of cashflows in another currency with all exchanges occurring at the same exchange rate. The Par Forward is therefore a series of foreign exchange forward contracts at one agreed rate. It is not necessary for the cashflows to be of the same notional amount. The Par Forward potentially has taxation and accounting implications for the user and so independent advise should be sought before use (see Notes section below). Also known as a Flat Rate Forward. More complex versions of the Par Forward include the Floating Rate Par Forward and the Rolling Par Forward.
EXAMPLE
An Australian company will receive USD 10,000,000 in dividends per year for 3 years. Traditionally the company has sold the USD forward and bought AUD. Given the interest rate differential (AUD rates higher than USD rates), the forward rates improve with tenor. For example, while the current spot rate is 1USD = 0.80AUD, the exchange rate for delivery in one year is 0.75, 2yrs 0.70 and 3yrs 0.67. The company would normally enter into three separate contracts as follows:
Time |
Company Sells |
Fwd Rate |
Company Buys |
1 year |
USD 10,000,000 |
0.7500 |
AUD 13,333,333 |
2 years |
USD 10,000,000 |
0.7000 |
AUD 14,285,714 |
3 years |
USD 10,000,000 |
0.6700 |
AUD 14,925,373 |
Alternatively, the company could utilise a 3 yr Par Forward at say 0.7075 with the following cashflows:
Time |
Company Sells |
Fwd Rate |
Company Buys |
1 year |
USD 10,000,000 |
0.7075 |
AUD 14,134,275 |
2 years |
USD 10,000,000 |
0.7075 |
AUD 14,134,275 |
3 years |
USD 10,000,000 |
0.7075 |
AUD 14,134,275 |
The Par Forward has the effect of "advancing" some of the AUD cashflow. The sum of the cashflows is not the same as the straight forward transactions (see Pricing section for full explanation).
The Par Forward allows the company to receive the same amount of AUD each year with the early cashflows at a rate substantially more attractive than the market rate.
Like any forward, the Par Forward not only provides an exposure to the FX spot rate, but also to the interest rate differential between the two currencies involved. In effect, the company is receiving a fixed rate of interest in the currency bought forward, and paying a fixed rate of interest in the currency sold forward. In this example, the company would be receiving AUD fixed rate and paying USD fixed rate. If this does not coincide with the interest rate view of the company, they may wish to utilise a Floating Rate Par Forward.
PRICING
There are a number of ways to consider the Par Forward. Simplistically, the Par Forward is a series of forward contracts where the forward rates are adjusted so that some of the forward exchanges "subsidise" the others such that they are all equal amounts. As a "rule-of-thumb", the Par Forward rate will approach that of the weighted average of the FX Forward rates. This is not 100% accurate as it fails to take into account the concept of present value.
The Par Forward rate is calculated as follows:
PV (CCY1 cashflows) * Par Forward Rate = PV (CCY2 cashflows)
where the Present Value (PV) for each series of cashflows is calculated using that currencies zero coupon discount factors
Another way to think about the Par Forward is graphically:
The Par Forward rate is that rate such that the PV of Area A equals the PV of Area B. Where the interest rate differential is favourable (i.e. higher interest rate in the currency being bought), the Par Forward rate will be more attractive than short term forward rates and less attractive than long term forward rates as in the example above. In cashflow terms this results in improved cashflows in the short term. Where the interest rate differential is not favourable, the Par Forward rate will be less attractive than short term forward rates and more attractive than long term forward rates.
TARGET MARKET
The Par Forward is an appropriate alternative for any user of FX Forwards. It is particularly attractive where the company or investor desires a hedge for a stream of future cashflows. The cashflows being hedged do not need to be at regular intervals or for the same notional amount.
NOTES
By its nature, the Par Forward changes the timing of cashflows from what would normally be expected when using FX Forward contracts. This therefore has taxation and accounting implications. As in the example above, the Par Forward may result in some forwards being exchanged at better than market rates while others are at worse than market rates. Depending upon the accounting method utilised by the user, this may result in an over or under statement of profits or losses.
ADVANTAGES
Simplicity. All forwards at one rate
Par Forward rate can be better than short term forward rates (if interest differential is favourable)
Cashflows are not required to be equal or regular
Potential accounting benefits
DISADVANTAGES
Potential taxation and accounting implications
PRODUCT SUITABILITY
Simple Defensive