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Break Forwards - Chapter 11

D

Daleth

Member
The notes describe a break forward as "a forward foreign exchange contract that contains an option giving the buyer the right to 'break' the agreement to exchange currencies." (Page 17.) They go on to say that, unlike options, "break-forwards fo not require a premium to be paid... as all costs are instead allowed for in the forward rate agreed at outset."

As far as I can tell this is a type two arbitrage: zero initial cost and a non-negative payoff at maturity. Regardless of how out-the-money the forward rate is, the forward costs nothing to enter (there is no premium), and can only have a positive payoff (the buyer can choose to break the agreement). Is there something that I have missed?
 
break forward

Hi
I see what you mean. The description in the course notes looks surprisingly similar to the one in the financial dictionary:
http://www.anz.com/edna/dictionary.asp?action=content&content=break-forward

Surfing a bit more lead to me to another article which I think holds the answer:
The Break Forward is another hybrid financial instrument. The Break Forward was a combination of a forward contract to buy currency A and sell currency B at a fixed forward rate and an attached optional contract, an option, to do the opposite, sell currency A and buy currency B, at a different rate, the break rate. In addition under the Break Forward, there is no premium paid up front. The insurance costs built into the prices of the two explicit contracts and these are settled on maturity. The construction of the Break Forward therefore requires another contract, a loan contract to defer the payment of the implicit option premium.

The three products together through the Put – Call parity principle of options actually result in being equivalent to another option. An option to buy currency A and sell currency B.
So the key is that the break forward is an obligation to trade currencies at one rate and an option to reverse the trade "at a different rate". So even if you break the deal you still have to trade at one rate and reverse it at another, which will lead to a loss. So no premium up front, but potential loss at the end. Hope this helps.
 
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