TARF from a Treasurer’s point of view - Definitions

TARF #2: 

This article is the first in my series on TARFs, which I had mentioned in my original post last week. Today we look at the definition of TARF and discuss why they are so widely used. 

An FX TARF is composed of a series of currency forwards with a cap on the sum of payoffs from the forwards that settle in favour of the (structure) buyer. Once the cap is reached, the structure ‘knocks out’ or - in other words - ceases to be active. Variations include the cap being defined in terms of FX points or number of legs. Visually depicting the payoff of a TARF can be tricky because of the infinite number of possible outcomes from a structure. In our first post on this topic, we revealed a way of depicting the payoff of a TARF in an animation which encapsulated the path-dependent nature of the payoff. Please check out my earlier post for the same.  

Why TARFs are ubiquitous:

The simple answer is - Treasurers get them. They understand the structure well and can visualise how it fits into their risk management strategy. TARFs are OTC (over-the-counter) products, which has meant that clients looking to utilise them as hedging instruments need to have credit facilities with their counterparties. I do hope that clearinghouses will add the capability to clear this trade soon. Fortunately, there is ample liquidity in the OTC TARF market and banks and FX brokers are falling over themselves to offer the product to their clients. The relative simplicity of understanding and adequate liquidity has made the TARF very popular.

Illustration:

Let’s take a case of a UK corporate exporting to the US thereby earning in USD. Its costs are denominated in GBP and it needs to sell its earned USD into pounds to pay its local costs. Say it needs to convert $100,000 every fortnight for the next 10 months. Trading a plain vanilla forward will fix the exchange rate at 1.3105 (say) for all these 20 payments. However, they are looking for a 2￠ improvement on the market. Using a TARF, the treasurer instead fixes the rate to buy pounds paying 1.2905 and fixes an upper limit to the amount of profit that can accumulate from the legs that settle in their favour. The structure knocks out once that cumulative profit cap is reached. The net payoff from the forward is cashed in as soon as the target profit is accrued and the structure ceases to exist. 

In my subsequent articles in this series, I shall discuss some of the criticisms of the structure, how a treasurer may design a TARF based on desired outcomes, and the potential payoffs in relation to the underlying risk.