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Target Redemption Forwards as FX Hedges: Knockout and Optionality Risks

Article Quant Q&A · Author: lakshmen
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Summary

The document presents two views on using a target redemption forward (TARF) to hedge foreign exchange exposure. One view emphasizes the knockout feature: if the exchange rate moves substantially against the underlying exposure, the TARF may terminate, leaving the hedger without protection when it is most needed. This makes the hedge’s protection conditional rather than continuous.

The other view says a TARF can hedge FX exposure, while stressing that its capped total payoff adds optionality and makes the instrument’s value nonlinear in the exchange rate and dependent on volatility. Together, the answers show why “can be used” and “is a reliable hedge” are different questions. The document gives conceptual arguments rather than a payoff analysis or empirical evidence; suitability depends on the contract terms and the exposure being hedged.

Key ideas

  • A TARF can provide exposure that offsets an underlying foreign exchange exposure.
  • A knockout can end the contract after an adverse market move, removing protection when it may be most valuable.
  • The payoff cap adds optionality and makes the instrument’s value sensitive to exchange rate volatility.
  • Hedge suitability depends on the contract’s features and the risk being hedged.

Tags

ForexOptionsDerivatives pricingRisk management
Full text
# Why a Target Redemption Forward cannot be used as hedging instrument?


# Why a Target Redemption Forward cannot be used as hedging instrument?












A Target Redemption Forward (TARF) allows you to buy or sell foreign currency at an agreed “Enhanced Rate” for a number of expiry dates. But why can't a Target Redemption Forward (TARF) be used as a hedging instrument?

## Answer by Roger Martin (score 3)

https://quant.stackexchange.com/a/48645

Have a slightly different take. While a TARF provides exposure to FX, it tends to knock out when you need it the most (i.e. when the TARF is deep ITM/when spot has moved substantially against you on the underlying), leaving you naked on your underlying exposure, and is therefore not a proper hedge.

## Answer by Antoine Conze (score 1)

https://quant.stackexchange.com/a/34280

Since it provides exposure to the FX a TARF can perfectly be used as a hedging instrument. However a TARF contains an optional component (cap on the total payoff) that makes it non linear in the FX and thus makes it depend on the FX volatility as well.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.