A bonus forward is an option with a strike and a knock out trigger; if the trigger is hit, the option becomes a synthetic forward with a predefined forward rate that is different from the strike defined for the option.
It consists of both of the following:
- Buying (selling) a put (call) knock out with one strike.
- Entering into a synthetic forward whereby you buy (sell) a put (call) knock in and sell (buy) a call (put) reverse knock in both with the same strike.
How does it work? The buyer selects a strike (A), a knock out trigger (B) and a forward rate (C).
If by the expiry date the spot:
- Has not touched the knock out trigger (B) and the spot gives a better rate than the strike(A), you exchange your notional in the open market.
- Has not touched the knock out trigger (B) and the strike (A) gives a better deal than the spot, you exercise the option.
- Has touched the trigger (B) the deal becomes a regular forward whereby the currency exchange is made at the forward rate (C).
Why buy a bonus forward?
This strategy lets you enter into a position where you are fully hedged in the event of an adverse spot move with the opportunity to enjoy a limited participation in any favorable spot move.
There is only limited participation in any favorable spot move because you pay zero or little premium for this strategy.
For example, you are an American corporation and you have receivables in Euro in 5 month.
- You can sell the Euro Outright (Forward) 1.2965
- Here you are locked in to this deal and cannot benefit from any favorable spot move.
- You can buy a Vanilla option Put Euro 1.2700 at 1.21%
- You are fully protected and can fully benefit from a favorable spot move but it is expensive.
- You can buy a Put Euro with a KO at 1.3230 and pay 1%
- This is cheaper than the vanilla but you have the risk that the option will knock out and leave you unprotected.
- You can enter into a bonus forward where you buy 1.2700 Put with 1.3700 KO, Sell 1.3130 Euro Call with 1.3700 RKI, and buy 1.3130 Euro Put with 1.3700 KI for ZERO cost
- What the strategy offers you is the following:
Protection against Euro depreciation (1.2700 and downwards) so you are fully hedged.
A possibility for an improved hedging rate if the Euro appreciates but does not hit the KO (1.3700).
A possibility for an improved hedging rate (1.3130) if the KO (1.3700) is hit. All this for zero cost.