Target Redemption Forward
Also known as: TARF, TARN, Target profit forward
A hedge that pays a better rate than the market until it has paid enough — then it stops protecting you and starts multiplying against you.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat is it, really?
A company that will receive foreign currency next year can lock in a rate with an FX forward. Simple, and the rate is whatever the market offers.
A target redemption forward offers a better rate than that. The catch is in two parts.
First, the deal ends early. Every month you make a small gain against the market, that gain is added up. When the total reaches an agreed target, the whole structure cancels itself and your hedge is gone — usually just when the market has been moving your way.
Second, if the market moves the other way, there is no target and no cancellation. Many versions double the amount you must exchange when you are losing. So the good outcome is capped and ends early, and the bad outcome runs on at twice the size.
- Asset class
- FX derivatives
- Instrument type
- Structured forward with a knock-out target
- Traded
- OTC, bank to corporate
- Typical users
- Corporate exporters and importers
Which risks decide the outcome
Not how risky this is, and not a rating — there is deliberately no total. It says which of five failure modes drives what happens here, in the same order on all 129 products so they can be compared. This publication's own reading; see the notice below.
- Marketdecides it
- Creditbarely applies
- Liquiditybarely applies
- Fundingdecides it
- Operationalbarely applies
What decides it here. The currency decides it and the leverage clause decides how much. Funding matters because the losing side settles in cash on every fixing while the winning side has already knocked out.
3 · IntermediateHow it works in practice
The three clauses that define it
- The target: cumulative gain at which the structure knocks out. A low target means it dies quickly, which is the point at which the company discovers it is unhedged.
- The leverage factor: typically the notional doubles on fixings where the client is out of the money. This is the clause that turns a hedge into a position.
- The fixing schedule: monthly or weekly observations, each one a separate settlement. A structure with twenty-four fixings is twenty-four options, not one.
Why a treasurer signs it
Because the alternative is quoted side by side and looks worse. The forward rate is what it is; the TARF rate is visibly better, and it is presented as a hedge. The asymmetry is in the term sheet rather than in the comparison.
The pattern that recurs
Losses cluster in exporters of countries whose currency then moved sharply — the structures were sold as hedges, were accounted for as hedges, and behaved as levered directional positions. The instrument did exactly what it was documented to do in every case.
4 · AdvancedPricing & valuation
Decomposition
A TARF is a strip of forwards with a leverage multiplier and a path-dependent knock-out on cumulative intrinsic gain:
What the symbols mean
- cthe coupon rate
- Nthe normal distribution, or a count
- Sthe price of the underlying today
- Kthe strike: the price written into the contract
- lambdaan intensity, usually of defaults per year
with \(\lambda\) the leverage, usually two. The knock-out depends on the sum of past gains, so the structure is path-dependent in a way that no closed form covers; valuation is by Monte Carlo, and the sensitivities are unstable near the target.
Where the risk actually sits
- Short volatility, asymmetrically. The client is short a strip of options on the losing side and long a strip that gets cancelled on the winning side.
- Short correlation across fixings. A trending market kills the structure early or runs it painfully; a mean-reverting one is benign.
- Gap risk at the target. Delta jumps discontinuously as cumulative gain approaches the knock-out, which makes the position hardest to unwind exactly when it needs unwinding.
The accounting trap
Hedge accounting requires the instrument to offset the hedged item. A structure that knocks out leaves the exposure unhedged from that date, and one that levers up hedges twice the exposure — neither is a match. Structures of this type have repeatedly failed effectiveness testing after the fact, converting an operational loss into a reported one.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow practitioners think about it
Now say it back
Close the page and give Target Redemption Forward in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — two parties wanted opposite things badly enough to write it down.
- What the contract obliges, and when — not the payoff; the obligation.
- Where the money comes from — name the source, or you have described a hope.
- What makes it lose — the ordinary way, not the dramatic one.