FIN.14:5 - Archetypal Grounding

The corporation expects a customer to pay 100 foreign units on day 30. A physical forward obliges it to deliver 100 foreign units and receive 90 home units that day. Assume the customer pays only 60, the unpaid claim of 40 remains, and the forward still requires delivery of 100. At spot 0.95 home per foreign unit, buying the missing 40 costs 38 home units.

If the corporation obtains that money and buys the currency in time, it delivers 100 and receives 90: current net home cash from the purchase and forward is 90−38 = 52, with the customer claim of 40 foreign units still outstanding. If it cannot fund or purchase the missing currency, there is an execution problem. The forward did not eliminate credit or volume risk.

For a separate rate example, debt pays a floating reference plus 2%, and a swap on the same notional and dates receives exactly that floating reference and pays fixed 4%. The matched net rate is 6% before other costs. A different reference, reset or floor breaks that simple cancellation and must be modeled.

FIN.14:5.1 - Compare a fixed amount, a smaller amount and optional protection

Before committing to a hedge, consider an original constructed comparison for a customer expected to pay 100 foreign units at T. The action-changing scenarios collect either 100 or 60 at T and have a spot rate of either 0.80 or 1.00 home per foreign unit. In the 60-collection cases, the claim on the remaining 40 persists; its later recovery and value are outside these current-cash figures and must be considered separately in the whole financial choice.

Four available alternatives are left unhedged, a physical forward sale of 100 at 0.90, a physical forward sale of 60 at 0.90, and a cash-settled put on 100 at strike 0.90 costing 2 home units now. The put pays 100 × max(0.90 − S, 0) at T. The illustrative offers have no other fees or collateral, all counterparties perform, necessary physical purchases are obtainable, and time value is stipulated zero for this comparison. Actual funding capacity is tested separately.

Each forward result follows Q × S + h × (0.90 − S). For example, with collection 60 and spot 1.00, the forward for 100 requires buying 40 for 40, then delivering 100 for 90, leaving net current home cash 50. The smaller forward uses the 60 received and pays 54. The put expires without payoff, so selling the 60 at spot and subtracting its earlier premium gives total cash contribution 58.

Suppose the stated objective is a net cash contribution of at least 55 across these four cases, after the protection premium. Only the put meets that objective among the four alternatives. That is a conditional selection, not universal superiority: its premium of 2 must be payable now, and the forward purchase may require interim funding. If only 1 is available for the premium and no further money is obtainable, the put is not feasible. The comparison then returns the need to change the objective, obtain a different attainable arrangement or change the underlying exposure.

With zero collection and spot 1.00, the put pays nothing and the total contribution is −2. The four-case selection therefore does not protect against complete nonpayment. A guarantee or collection response has a different covered event and must be assessed on its actual terms. A cash-settled option also does not automatically reduce its notional when collection falls: the proposed 100 remains a separate position. If it is no longer appropriate, reconsider it with the outstanding claim and available modification terms.

This comparison occurs before commitment. In the existing partial-receipt case above, the corporation already owes delivery under its forward; it cannot retrospectively choose the better column.

FIN.14:5.2 - Reduce an existing forward after the expected receipt changes

In a separate constructed case, a forward already requires delivery of 100 foreign units for 90 home units on day 30. It was based on forecast orders. At the new decision date, day 15, the revised orders support a receipt of only 60 foreign units on day 30; the other 40 were uncontracted forecast sales, so no customer claim for them exists. This differs from partial payment of an existing invoice. Assume the stated 60 is collected in both compared scenarios.

A new forward for the same settlement date is quoted at 1.00 home per foreign unit. With zero discounting for this contract-value comparison, the old sale at 0.90 has value 100 × (0.90 − 1.00) = −10. The bank offers an amendment that, once agreed and paid on day 15, extinguishes 40 of the delivery duty for a payment of 4 plus a new charge of 0.40. The remaining duty is to deliver 60 for 54 on day 30, with current value −6. The payment 4 settles the removed portion’s existing value; 0.40 is the additional amendment cost.

The corporation has usable home cash 5 and a separate collateral claim of 10 already posted before day 15. Under the stipulated arrangements, continuing leaves all 10 blocked until completed settlement on day 30. The amendment returns 4 on day 16 and retains 6 until completed settlement on day 30. No further collateral calls occur in these compared paths. An unrelated committed home receipt of 50 arrives on day 20. The cash reserve is 2 throughout. All parties perform the stated payments and collateral releases; there are no taxes or other flows. An initial dealing fee of 0.20 was paid before day 15 and is already reflected in the opening cash.

Continue the original forward. Home cash becomes 55 on day 20. On day 30, buy the missing 40 foreign units before delivering 100. At a spot rate of 0.80 this costs 32; at 1.20 it costs 48. Even the larger purchase leaves usable cash 7 before the forward receipt. Receipt of 90 and return of collateral 10 then leave 123 or 107. Continuing requires no new day-15 payment, but retains the price exposure on the excess delivery quantity.

Accept the amendment. Paying 4.40 immediately from cash 5 would leave 0.60 and breach the reserve. An obtainable bridge advances 1.40 net on day 15 and requires repayment of 1.50, including its charge, on day 20. The cash path is 5 + 1.40 − 4.40 = 2 on day 15; 6 after the collateral return on day 16; and 6 + 50 − 1.50 = 54.50 on day 20. On day 30, deliver the collected 60 for 54 and receive the remaining collateral 6. Ending home cash is 114.50 in either spot scenario.

If the objective is at least 110 of ending cash in both scenarios while maintaining reserve 2, the funded amendment meets it and continuing does not. If the bridge is unavailable, the amendment on these payment terms is infeasible. If the released collateral 4 is instead actually usable before the amendment payment, the bridge is unnecessary and ending cash is 114.60. That changed timing saves the bridge charge; returning already owned collateral is not a new hedge profit.

The later choice retains the old loss and its remaining contractual effect. It does not recreate an initial choice of a forward for 60 at today’s rate without paying for the old position. FIN.13 receives the reduced delivery exposure; FIN.2 receives the amendment payment, collateral dates and bridge repayment; FIN.15 obtains the actual amendment effect and performs the funded actions.

FIN.14:5.3 - An eventual offset can require cash first

Consider a separate cash-settled forward sale of 100 foreign units at 0.90, paired with a receipt of 100 at day 30. Assume zero discounting and an enforceable term requiring cash collateral equal to an adverse marked value. On day 15, the remaining forward price is 1.00, so the seller’s forward value is −10 and collateral 10 must be posted by day 16. Usable cash then is 6 and the required reserve is 2. Only 4 is free for this purpose, leaving a funding need of 6.

Suppose the spot rate is 0.80 on day 30, the customer pays in full, and the forward counterparty pays the resulting gain of 10 and returns all collateral 10 at that time. The operating receipt converts to 80. The hedge’s dated cash is −10 on day 16 and +20 on day 30, for net 10 before funding costs; combined net cash from receipt and hedge is 90. Counting the collateral return as an additional profit would overstate that result by 10.

The eventual protection is therefore effective under these stated performance conditions, but it was not executable without the missing interim 6. FIN.2 assesses an obtainable response and its repayment; FIN.15 performs it within authority. A different margin rule, return date or failed counterparty changes both the funding and protection comparison.

FIN.14:5.4 - Basis and contractual floors leave different residuals

A manufacturer plans to buy 100 commodity units. The physical price is a traded reference plus a local basis. Initially those amounts are 50 and 5 per unit, and the initial futures price is also 50. A perfectly performing futures offset gains the increase in that reference on 100 units, with margin funding assumed available. At purchase, the reference is 60 but local basis is 9: physical cost is 6,900 and the hedge gain is 1,000, leaving net cost 5,900. The initial implied cost was 5,500. The residual 400 comes from the local basis, which the selected contract does not fix. Changing physical quantity also requires recomputing the offset amount.

For the rate example above, change the debt to pay max(reference, 0) + 2%, while the swap still receives the unfloored reference and pays fixed 4%. At a reference of 3%, total debt and swap cost is 5% + 1% = 6%. At a reference of −1%, debt costs 2% and the swap costs 5%, giving 7%. The debt floor defeats the claimed constant 6% even though notional and dates still match. A change in the loan’s credit spread can leave another residual; matching the base reference does not fix that spread.