Lesson 20 of 25 · 7 min

A prepaid variable forward, mechanically

Cash arrives now against shares delivered years later, and how many shares depends on a price nobody yet knows.

A prepaid variable forward is one contract that does three things at once: it pays cash up front, it fixes a floor and a ceiling on the price you will realise, and it commits shares for delivery at a date years out. Taking the three apart is the whole of this lesson.

Take 30,000 shares at $76.40, so $2,292,000. The contract sets a floor at 90 percent of the price, which is $68.76, and a ceiling at 130 percent, which is $99.32, with settlement in three and a half years. The prepayment is 79 percent of current value: $2,292,000 × 0.79 = $1,810,680, received at the outset.

At settlement the value you realise per share is the settlement price, bounded below by $68.76 and above by $99.32, and the prepayment is an advance against it. Below the floor you realise 30,000 × $68.76 = $2,062,800, so a further $252,120 settles up. At $85 you realise $2,550,000 and $739,320 settles up. At $137 the ceiling binds: you realise $2,979,600, a further $1,168,920 settles, and 30,000 × ($137 − $99.32) = $1,130,400 of appreciation goes to the counterparty.

Two mechanical details sit behind those rows. Settlement can be in shares or in cash depending on the contract, and the number of shares required therefore varies with the price — which is what the word variable is doing in the name. And the prepayment is not a loan against the shares in the sense Track 1 used: there is no interest rate, no maintenance threshold and no margin call, because the counterparty's protection is the delivery obligation itself.

Key terms

Prepaid variable forward: A contract paying cash now against shares or cash delivered at a set future date, with the amount delivered varying with the settlement price.
Prepayment percentage: The share of current market value advanced at the outset. It is set by the floor, the term and the volatility of the shares.
Participation band: The floor and ceiling between which the settlement price passes through to you. Outside the band, one side of the contract absorbs the difference.

Worked example

One contract, three settlement prices

30,000 shares at $76.40, so $2,292,000. Floor $68.76, ceiling $99.32, term three and a half years, prepayment 79% of current value. Illustrative terms.

Prepayment received at the outset: $1,810,680
Settlement at $52: total realised: $2,062,800
Settlement at $85: total realised: $2,550,000
Settlement at $137: total realised: $2,979,600
Appreciation forgone at $137: $1,130,400
Interest charged on the prepayment: None

Seventy-nine percent of the value arrived immediately, the outcome was bounded at both ends, and the shares were committed for three and a half years.

Check yourself

A prepaid variable forward on 12,000 shares at $50 sets a floor of $45 and a ceiling of $66, with a prepayment of 80 percent of current value. At a settlement price of $74, what do you realise in total, and what is forgone?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.