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What is a break forward? How to use it in a trading deal?

What is a break forward? How to use it in a trading deal?

 

What is a break forward? How to use it in a trading deal?

 

To understand what a “break-forward” is, you must first understand the wide variety of types of market transactions. In this case, we are interested in exactly the criterion called "asset delivery time", depending on this criterion, transactions are divided into:

spot transactions - transactions with immediate delivery of goods (although as immediate, usually implies a period of up to 2 days);

forward strikes (derivatives transactions) - transactions involving settlements after a specified period of time (week, month, etc.).

It may seem that futures deals are somewhat reminiscent of futures, which essentially imply the same rules, but futures are exchange transactions, and forward transactions are not exchange contracts that are concluded for any period by agreement of the parties. Most often, such transactions are used precisely in the foreign exchange market.

 

In fact, the forward contract involves the delivery of goods (currency) in the future at the price that we agreed upon in the present when signing such a contract. That is, if we entered into a forward contract for the supply of 1 dollar in three months at a price of 65 rubles, then we will be delivered at exactly that price in three months, all depending on the future price, that is, a dollar may cost already 100 rubles, but we will put it at 65.

 

However, there are also fixed-term contracts that imply the right to prematurely close a transaction, that is, this is some kind of mixture of a forward transaction and a currency option. It is to such contracts that the “break forward” subspecies refers.

Break forward (break forward) - forward contract, which can be executed ahead of schedule at a pre-agreed rate.

Such a contract provides for the buyer's right to close the contract when the price reaches the so-called “break level”. Let's try to consider the same example with the ruble.

 

Suppose that our company received equipment from a European company and must pay 100 thousand euros for it after 6 months. We entered into a break-forward contract with the bank for the exchange of rubles to euros at the rate of 75 rubles for 1 euro, it turns out that after 6 months the total cost of the equipment will be 75 rubles * 100,000 = 7.5 million rubles. The cost of a break under a break-forward contract is 500 thousand rubles. That is, in case of early termination of the contract, we must pay the bank 500 thousand rubles. Six months have passed, and now two options are actually possible:

the rate has grown, suppose to 79 rubles;

the rate fell, suppose to 65 rubles.

In the first case, we simply close the contract at a predetermined price of 75 rubles, despite the fact that the market price is 79 rubles and thereby save 4 rubles from each euro or in the amount of 4 * 100 000 = 400 000 rubles.

 

In the second case, we will initially consider whether it is profitable for us to make a “break”, that is, to break the contract. To do this, we multiply the current market price (spot rate) by the delivery amount, i.e. 65 rubles (spot rate) * 100,000 (contract amount) = 6.5 million rubles. And now we recall that at a delivery price of 75 rubles per euro (which we set at the time of signing the contract), we had to spend 7.5 million rubles. We add here that when using the "break" right, we must pay the bank 500 thousand, that is, if we break the contract, we must pay the bank 500 thousand, and then we can buy euros at the spot market at 65 rubles per euro, that is, our total costs will be: 500 thousand (bank premium) + 65 rubles (spot rate) * 100 000 (the amount of the required currency) = 500 thousand + 6.5 million = 7 million rubles. So in this case it’s more profitable for us to use the right to break the contract.

 

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