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A forward contract locks in a specific price for an underlying asset, which could be a commodity, foreign exchange rate or other financial instrument. When two parties sign a forward contract, they take on an obligation to buy or sell a fixed amount of the underlying asset to the other party at a specific price on a certain future maturity date. Instead of a specific price, the range forward contract locks in a range of prices for the underlying asset. This lets the holder benefit from small moves in prices while protecting himself from larger moves.
A range forward contract sets a range of prices for the underlying asset and a maturity date. If the price of the underlying asset at maturity is below the range, the parties of the contract will make a transaction at the lowest rate within the range. If the price of the underlying asset at maturity is within the range, the transaction will be at the market rate. If the price of the underlying asset at maturity is above the range, the transaction will be at the highest rate within the range. The transaction will never be conducted below or beyond the range.
For example, an American company expects to buy Great Britain Pounds (GBP) in three months and the US Dollar (USD)/GBP rate is currently 1.6273. The company can enter a range forward contract with a band from 1.6000 to 1.6400. At the end of the three months, at the maturity date, if the USD/GBP rate is below 1.6000, the company will buy the currency at $1.6000 USD/GBP. If the USD/GBP rate is between 1.6000 and 1.6400, the company will buy it at the prevailing exchange rate. If the USD/GBP rate is greater than 1.6400, the company will pay $1.6400 USD/GBP for it.
The holder of a range forward contract often uses it to hedge or protect a position in the underlying asset. For example, a company expects to earn income or make a payment in a foreign currency and wants to ensure that it does not suffer losses because of exchange rate fluctuations. A farmer producing a commodity might also sign a range forward contract to ensure a minimum price for his next harvest.
There are often no upfront costs to enter a range forward contract. Being a contract between two parties, the parties can tailor the terms to suit their preferences. The disadvantage of a range forward contract is that the floor rate, which is the lowest rate within the specified range, is usually lower than the rate of a simple forward contract. The holder also cannot fully take advantage of a favorable price movement because of the existence of the ceiling rate.