2022 witnessed a significant strengthening of the US Dollar which increased importers’ USD purchasing costs dramatically.
Whilst many importers will have benefited from the protection afforded to them by their legacy hedging programmes, as those hedges rolled off, they would have found themselves increasingly exposed to the more challenging rate environment. This would have resulted in them either having to accept lower profit margins or to adjust prices higher and risk a reduction in demand.
Against this backdrop, many banks and specialist FX providers marketed outperformance strategies that offered their clients a means to reduce the cost of purchasing USD relative to the traditional FX forward. Whilst these strategies may have been tempting, it is important that the risks inherent within them were properly understood and that they were used correctly.
This article reviews one of the more popular outperformance strategies, the Target Accrual Redemption Forward (TARF), otherwise known as the Target Profit Forward (TPF).
What is a TARF?
A TARF is a structured FX forward that offers an enhanced rate that is considerably more attractive than the equivalent market forward. As the below Net Exposure Profile diagrams show, the TARF is similar to a Ratio Knock-Out Forward.
The key difference between the two is how the cancellation event operates:
Unlike the Knock-Out Forward, a TARF guarantees a degree of protection in the form of the target and is sometimes described as a partial hedge. This is one of the reasons why some users of the strategy favour it.
The TARF is a highly asymmetric strategy given that the gains are limited to the target, but the losses are unlimited and will more often than not report a negative mark-to-market to the client.
How is rate enhancement obtained?
Enhancement is made possible by the inclusion of a condition that limits the maximum gain (profit) to a pre-defined value. This value may be expressed either as a:
Cash sum (used in Chooser TARFs)
Number of in-the-money fixings (used in Counter and Discrete TARFs)
Number of pips / big figures (used for the majority of TARF variants
Once that value is realised, the strategy will terminate, and the client will find itself unhedged for the remaining dates specified within the schedule.
Improving the enhanced rate further
The rate can be further enhanced via the introduction of leverage. This can either be expressed within the Notional schedule, through time, or within the rate offered.
Common examples, include:
Ratio: Where the client is protected on 1x Notional Amount, but obligated on an increased amount, e.g., 2x Notional Amount.
Penalty Rates: Where the client could be reset into an obligation rate that is less favourable than the initial rate targeted.
Variable Notional and Strike Schedules: Where later fixing dates have larger Notional Amounts and/or less attractive Strikes than earlier fixing dates.
Extendibility: Where the strategy will continue into a second period if it has not realised its target and satisfies the extension condition.
For example, the TARF provides 12x monthly fixings (Part One).
If the strategy has not terminated prior to its final fixing and satisfies the extension condition, it will continue on the same terms for a further 12x monthly fixings (Part Two).
Conditional Feature: Provides the client with a replacement TARF which takes affect at the earlier of: The TARF realising its target value and terminating; or It reaching its final fixing.
Chooser Feature: Where the strategy compares the payoff of two currency pairs and provides the client with:
The smaller gain, when the strategy is viewed as working for the client; or
The larger loss, when the strategy is viewed as working against the client.
An example of a Chooser TARF is one where a client enters into a strategy to buy USD, funded by either GBP or EUR.
What are the risks of using a TARF?
A) Risk of becoming unhedged / under-hedged
The TARF only provides a partial hedge, which is limited to the target. Once the target is realised, the strategy will terminate and the client will become unhedged. This will most likely arise at a time when re-entering into a newly hedged position would see the client receiving less favourable terms.
Furthermore, this partial hedge will only be on the protected notional, which, if less than the obligation amount (which is typically the case), will lead to them being underhedged.
Clients that require guaranteed protection should consider alternative strategies that deliver definitive protection. However, if a decision is made "not to hedge", and instead to wait for rates to improve to a more attractive entry level, then the TARF may be considered a valid risk management strategy. Especially since it enables the client to monetise the risk that it would otherwise have faced by being unhedged.
B) Risk of becoming over-hedged
A key risk inherent in the use of TARFs is that clients over commit themselves. This is commonly seen where the client becomes obligated to transact the total leveraged notional amounts across all dates.
To guard against this eventuality, clients should work backwards by defining their total exposure and only enter into TARF positions that would commit them to that amount.
Unfortunately, the psychology behind the use of TARFs often sees clients viewing the strategy as one that offers a high probability of securing short-term profits with a low probability of suffering losses.
Given the risks, why are TARFs so popular?
Quite simply, TARFs offer a way to target far more attractive rates.
This is best illustrated by the case study below that compares the FX forwards rates available to hedge end of month cash flows across 2023, against those offered by a TARF.
In the extreme example, the importer can target rates that are 20% more favourable.
CASE STUDY
During 2022 an European Importer with an ongoing requirement to buy USD evenly across 2023, with end of month settlements, found its ability to achieve its desired budget rate challenged by the sharp depreciation of the EUR against the USD that had occurred during the year.
Key Issues
Budget rate of 1.0500 set earlier in 2022.
The move lower in EURUSD to 0.97 by October 2022 made it impossible to fix forward at levels that would achieve that budget rate.
Instead a ~6% negative variance (loss) would be crystallised if it proceeded to hedge with outright forwards.
With several months to go until a firm decision to hedge must be made, the importer's alternative would be to wait for rates to improve, and continue to take the risk that EURUSD spot remained at low levels or depreciated further.
A Potential Solution
Two alternative outperformance TARF strategies are examined below, alongside the FX Forward benchmark (presented in Option1) , one offering a ~8% improvement versus spot, the other a ~21% improvement.
Option 1: Strip of FX Forwards
0.9885 is the average rate currently available, using spot reference 0.9700.
Option 2: TARF that targets 1.0700
1.0700 is the strike rate offered by a TARF with 0.20 target and 2x leverage.
Were EURUSD to remain at the current 0.9700 level throughout 2023, the TARF would realise its 0.20 target upon its second fixing, in February, terminating thereafter and leaving the client unhedged.
Option 3: Variable Strike TARF, aggressively targeting 1.2000
Structure a 24-monthly TARF with both variable notional amounts (doubling from month seven onwards) and strike rates (targeting 1.2000 for the first six fixings, before stepping down to 1.0000 for all fixings thereafter).
This variation is designed to deliver significant enhancement and terminate quickly.
For example, assuming that EURUSD remains at current levels, even with a larger 50 big figure target, this strategy is structured to deliver 2-3 fixings at 1.2000 before terminating in March.
ASSESSMENT
With EURUSD near multi-year lows, the client may have found itself reluctant to fix forward and crystallise a loss versus its budget.
When one considers where EURUSD spot was trading against where it had historically traded (see graph above), it is understandable that the importer may have held the view that EURUSD would reverse and trend higher - reverting back to its mean.
Option 2 offered a way for them to target a 1.07 rate and outperform their budget by ~2% and the spot market (as priced at the time) by ~8% on an element of their exposure.
Option 3 used considerable leverage to target a more aggressive 1.20 rate, which may have been viewed as more attractive. This would especially be the case if they held the view that EURUSD was likely to remain weak throughout 2023 and therefore the risk of the strategy lasting beyond its initial six fixings was deemed low. Such positions should be taken in moderation to avoid the risk of overcommitting oneself.
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