Derivatives | Z
Zero-Cost Collar Knockout
A zero-cost collar that is combined with a knock-out option. It allows investors/hedgers to buy or sell a foreign currency using a collared forward contract, i.e., at a rate that is guaranteed to belong to a specific range. By trading within this range, investors/hedgers can bet on the market direction according to their own views, rather than being confined to trading at a fixed forward rate. Two rate levels (a lower boundary and an upper boundary) create the range. At the expiration date, if the spot rate is trading above the upper boundary, then the foreign currency transaction will be capped by the upper level, and if the spot rate is trading below the lower level, then the foreign currency transaction will be floored by the lower level.
This collar has a knockout mechanism that distinguishes it from an ordinary collar. Though this knockout level actually places a cap on the profit potential, but the protection secured with such a product would justify trading it. The product remains in the money as long as the spot rate is trading above or below the knockout level. But when it touches that level, the whole structure automatically terminates, and the investor/hedger loses his protection.