What it means
Businesses that buy or sell in foreign currencies face the risk that rates move before payment. A plain forward contract removes that risk by fixing one rate, but it also removes the chance to benefit if the market moves in your favour.
A range forward is a compromise that gives some protection and some flexibility. The contract is built from two options bought and sold together, a bit like a collar.
The business buys protection at one end of the range and gives up some gain at the other, and the premium it pays on one side offsets the premium it receives on the other. Because they cancel out, the structure can be set up with no net upfront payment.
The width of the range is the trade-off. A narrow range gives near-certainty about the cost but little room to gain, while a wide range leaves more of the exchange-rate risk with the business.
Treasurers pick the band to match their budget tolerance, for example the worst rate at which a project still makes its margin. For accounting and planning, the contract provides a known worst case, which is what budgets and covenants (promises made to lenders) need.
It is less useful if the business wants the certainty of one rate, in which case an ordinary forward is simpler. It should also be matched to the real size and date of the exposure.
The nuance is that nothing is free. Even though no premium is paid, the business accepts that it will not benefit from moves beyond the edge of the range on the favourable side.
Banks also build their margin into the rates they offer for the band.
In practice
Real-world examples.
Example
A furniture importer must settle a supplier invoice in euros in 90 days. It uses a range forward to cap the dollar cost at the upper limit while still benefiting if the euro weakens a little. The finance team can quote customers with confidence about its worst-case margin.
Example
A software exporter expects to receive payment in a foreign currency from a large customer. It sets a range forward whose lower limit protects its minimum acceptable revenue. If the currency strengthens, the exporter collects the extra gain up to the upper limit.
Example
A construction company is bidding for an overseas project priced in a foreign currency. It buys a range forward to cover the contract payments. The bank sets the band wider than the company wanted, which lowered the cost to nothing but raised the uncertainty.
Formula
Calculation
Settlement rate for a buyer of foreign currency = the lower limit if the market rate is below it, the market rate if it is within the range, or the upper limit if it is above
A US importer must pay 1,000,000 euros in three months and takes out a range forward with a band of $1.05 to $1.15 per euro. If the market rate is $1.20, the importer pays the upper limit of $1.15, so the cost is 1,000,000 x 1.15 = $1,150,000, which saves $50,000 compared with paying 1,000,000 x 1.20 = $1,200,000. If the market rate is $1.10, the importer pays 1,000,000 x 1.10 = $1,100,000. If the market rate is $1.00, the importer must still pay the lower limit of $1.05, so the cost is 1,000,000 x 1.05 = $1,050,000.Case study
Seen in the real world.
Harlow & Finch Imports is an illustrative, fictional company that buys machinery from overseas suppliers invoiced in euros. A sudden currency swing had cost it $90,000 on a single order the previous year, so the new finance manager looked for a hedge.
A forward contract fixed the rate at $1.10, but the manager worried the company would regret it if the euro weakened. The bank offered a range forward with a band of $1.07 to $1.14, which capped the worst-case cost at $1.14 per euro while allowing the company to gain if the euro fell to $1.07.
On a 500,000 euro order, the worst-case cost was 500,000 x 1.14 = $570,000, which the budget could absorb. The illustrative point is that a range forward is about setting a worst case you can live with while keeping some upside.
Watch out
Common mistakes.
- Believing a zero-premium structure is free, when the business gives up gains beyond the edge of the range.
- Choosing a range so wide that the worst case no longer protects the budget.
- Hedging more than the real exposure, which can create a loss if the underlying payment does not happen.
Questions
People also ask.
How is a range forward different from a plain forward?
A plain forward fixes one rate, whereas a range forward fixes a band and lets the market rate apply inside it.
Is it the same as a collar?
It is very similar, as both combine a bought and a sold option, though range forwards are usually described this way in currency hedging.
Does it need upfront cash?
Usually not, because the premium paid on one option is offset by the premium received on the other, but the bank may require credit lines or collateral.
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