Prepaid Variable Forwards

CFA Level III Derivatives
#1

Prepaid Variable Forwards

A pre-paid variable forward (PVF) is a forward contract in which the investor agrees to sell a specific number of shares in the future at pre-specified future date in return for an upfront cash payment from the counterparty.

Does it mean the investor can get the upfront cash payment immediately and sell the shares later?

Standard forward contract will exchange position at specific date together. Is it the reason it calls variable forward?

#2

The variable here means that the shares he is selling at future date is not fixed…it’s variable. It may be 100 shares or 150 shares or some other number. It’s done mainly to hedge the concentrated stock positions.

#3

Got it. Thanks Cric!

#4

why would a dealer enter into PVF if he bears downside risk and no upside potential?

#5

In a PVF, the dealer has downside risk and unlimited upside potential.

The variable part of a PVF is the number of shares you have to deliver at expiration, which will depend on the share price at expiration.

A PVF is essentially a combination of an equity collar and a loan.

Suppose that you own 100,000 shares of ABC Company stock selling at $50/share. You enter into a 5-year PVF with a lower strike of $47/share and an upper strike of $55/share; today the dealer gives you $44/share ($4.4 million) for you to do with as you wish.

At expiration in 5 years:

  • If the share price is less than $47/share, you simply deliver all 100,000 shares.
  • If the share price is between $47/share and $55/share, you deliver $47(100,000) = $4.7 million worth of shares. For example:
    • If the share price is $48/share, you deliver $4.7 million / $48 = 97,917 shares.
    • If the share price is $50/share, you deliver $4.7 million / $50 = 94,000 shares.
    • If the share price is $55/share, you deliver $4.7 million / $55 = 85,455 shares.
  • If the share price is above $55/share, you deliver $4.7 million plus the excess of the share price above $55/share. For example:
    • If the share price is $60/share, you deliver $4.7 million plus ($60 − $55)(100,000), or $5.2 million; at $60/share, that’s 86,667 shares.
    • If the share price is $65/share, you deliver $4.7 million plus ($65 − $55)(100,000), or $5.7 million; at $65/share, that’s 87,692 shares.
    • If the share price is $100/share, you deliver $4.7 million plus ($100 − $55)(100,000), or $9.2 million; at $100/share, that’s 92,000 shares.

Note that you also have the option of settling in cash.

1 Like
#6

thank you for the excellent explanation! Are we supposed to know these calculations or just general understanding is enough?

#7

I suspect that a general understanding is sufficient, though the calculations aren’t difficult.

#8

+1, incredible

#9

You’re very kind.

#10

I put this into an article, with pictures: http://www.financialexamhelp123.com/prepaid-variable-forward-pvf/

#11

Hi all,

i came across Q8 in R11 (concentrated single asset position) p.347 vol2

it says that he wants a hedging strategy that allows him to lock in a floor price and retain unlimited upside.

The answer says protective put, I understand a protective put does that but isn’t a PVF supposed to limit downside and retain upside as well?

#12

I think the key word there is “unlimited” upside.

Like magician pointed out a PVF is like an equity collar which only retains upside potential to the strike price of the call, so it’s not “unlimited”.

Could be wrong

#13

Magician, in your example, how do the parties determine the $44/share price for the loan? Thanks.

#14

Bump for question to the magic man!

#15

I can’t say for certain – I’ve never constructed a PVF in real life – but it has to be based on the expected payoff from the PVF, the risk-free rate, and the (very low) riskiness of the loan. In this example, if the dealer expects that the share price in 5 years will be between the strike prices on the PVF, then the expected payoff is $47 / $44 = 1.0682. That works out to 1.06821/5 − 1 = 1.3279% per year. Maybe the risk-free rate is 1.30%.

#16

Magician, would you please enlighten me how do you cash settle it? the difference between maturity and strike price? I was puzzle because the term ‘deliver’ means sell to me and thus receiving cash. Since earlier I already received the loan, why am I receiving cash again? Is there something I’m missing? Thanks.

#17

When you settle in cash you pay the cash; you don’t receive cash.

If the share price is less than $47 per share, you can pay the value of 100,000 shares; e.g., if the price is $40 per share, you can pay $4,000,000 in cash

If the share price is between $47 per share and $55 per share, you can pay $4,700,000 in cash.

And so on.

#18

incredible!

#19

Hi All

Happy Christmas !! Request your help in understanding PVF.

As per Smagician’s example here, if the stock price at the expiration of the PVF is less than $47, we deliver all 100,000 shares to the dealer, the long put in this case is in the money who gets to keep the money the dealer?

If the stock is between $47 and $55 we give the dealer $47 worth of shares and dont share any upside with the dealer, so should we consider $47 as the fixed price the dealer expects in this transaction in return for lending $44 today ?

Thanks for the help as always !

#20

Yes, you are right. The key to understand this whole thing are as follows:

  1. We are essentially taking about Rf=6.82%. If 44 is the price today which will yield 47 over a 1 yr. HP.

  2. The lending ACTUALLY happens at Rf, hence it is likened a fwd. contract.

  3. It is called pre paid because it comes with a put option insurance ( the premium of which is the lending rate of Rf, accorded by the dlr.)

  4. The million dollar Q’s. is how the prices ( and hence the strike rates) of 47 and 55 decided. Now in the truest sense it is indeed an estimate based on binomial price movement over the horizon. ONLY if the stock has potential of clicking AT LEAST 47 over the horizon ( with say a probability of 99% or more), such contracts shall be underwritten.

  5. Because the dlr. shares in the upside potential beyond the upper strike price hence it is a VARIABLE contract ( i.e. At final delivery the no. of shares to be delivered is variable) also.

The rest of the math and explanation should be easy. In fact , I don’t think any further expln. is reqd. after the Magician delivers. He is unparalleled. But still, I just made an attempt …however lame.