Between signing and completion the seller's price is fixed and the buyer's is not; here is what it costs to fix it without betting on the deal closing.
A deal-contingent hedge costs the difference between its rate and the ordinary forward rate, paid only if the deal completes. On an illustrative GBP 200.0 million acquisition by a euro buyer, six months from signing to completion, a contingent forward priced 0.0100 above the 1.1585 forward costs 2.00 million euros, 0.86 per cent of the hedged amount, and nothing if the deal fails. A plain forward would have lost 16.43 million on a failed deal after an 8 per cent fall in sterling; an option would have cost 5.18 million whatever happened.
Worked in full in Closing the Deal by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Once the share purchase agreement is signed, the price is fixed in the seller's currency. The buyer's price is not: it moves every day until completion with the exchange rate. The gap can run for months while merger control and other conditions are cleared, and the question is how to fix the buyer's cost without taking a large loss if the deal never closes.
| Input | Value |
|---|---|
| Purchase price, GBP million | 200.0 |
| Spot rate at signing | 1.1700 |
| Euro interest rate, a year | 2.0% |
| Sterling interest rate, a year | 4.0% |
| Signing to expected completion, months | 6 |
| Deal-contingent premium over the forward | 0.0100 |
| Sterling volatility, for the option | 8% |
| Probability the deal completes | 85% |
Forward = spot × (1 + euro rate × t) ÷ (1 + sterling rate × t)
In Excel: =1.17*(1+2%*0.5)/(1+4%*0.5), which gives 1.1585.
Because sterling earns more interest than the euro here, sterling buys forward at a discount: the forward cost of the price is 231.71 million euros, against 234.00 at spot. That 2.29 million is carry, not a gain: it is what the interest differential is worth over six months.
The bank adds a premium to the forward because it gives the buyer a free exit: if a condition fails and the deal does not complete, the hedge is torn up at no cost. The bank prices that by its own view of the completion risk. At 0.0100 above the forward the contingent rate is 1.1685 and the euro cost 233.71 million.
Cost of contingency = notional × (contingent rate − forward rate)
200.0 × 0.0100 = 2.00 million euros, or 0.86 per cent of the forward cost. Weighted by an 85 per cent chance of completion, the expected cost is 1.70 million.
The comparison only makes sense across both branches: the deal completes, or it fails. The option is a call on sterling struck at the forward and priced with the Garman-Kohlhagen formula at 8 per cent volatility: 0.0259 a pound, 5.18 million euros paid at signing, ignoring interest on the premium.
| Sterling at completion | Unhedged | Forward | Contingent | Option |
|---|---|---|---|---|
| Falls 8% to 1.0764 | 215.28 | 231.71 | 233.71 | 220.46 |
| Unchanged at 1.1700 | 234.00 | 231.71 | 233.71 | 236.88 |
| Rises 8% to 1.2636 | 252.72 | 231.71 | 233.71 | 236.88 |
| Sterling at the failure date | Forward | Contingent | Option |
|---|---|---|---|
| Falls 8% | −16.43 | 0.00 | −5.18 |
| Unchanged | 2.29 | 0.00 | −5.18 |
| Rises 8% | 21.01 | 0.00 | −5.18 |
Unhedged, the price the board approved can land anywhere between 215.28 and 252.72 million euros, a range of 37.44 million on a single 8 per cent move. The forward fixes it at 231.71 but leaves an open position if the deal fails, and the loss case is exactly the one in which the buyer has no acquisition to show for it. The option caps the cost and has no failure risk, but its 5.18 million is spent in every branch. The contingent forward fixes the cost at 233.71 and costs nothing in the failure branch.
| Premium over forward | Cost if it completes | % of forward cost | Expected cost |
|---|---|---|---|
| 0.0050 | 1.00 | 0.43% | 0.85 |
| 0.0100 | 2.00 | 0.86% | 1.70 |
| 0.0150 | 3.00 | 1.29% | 2.55 |
| 0.0200 | 4.00 | 1.73% | 3.40 |
Each 0.0100 of premium is 2.00 million euros on this notional. Against the option's fixed 5.18 million, the contingent forward stays cheaper up to a premium of roughly 0.0259, the option's own price in the same units. The less likely completion is, the more the bank charges, because its free exit is worth more.
Price a deal-contingent hedge as notional times its premium over the ordinary forward, then weigh it against the forward's loss if the deal fails and the option's certain premium. Here 2.00 million buys a fixed cost of 233.71 million and a free exit. How the rest of the price moves between signing and completion is worked in the locked box ticker and in the free workbooks for Closing the Deal.
It terminates with no payment either way, which is what the premium buys. On a GBP 200.0 million price, a plain forward closed out after an 8 per cent fall in sterling would lose 16.43 million euros; the contingent forward loses nothing. Its cost, 2.00 million at a 0.0100 premium, is paid only through the rate on completion.
Usually, because the buyer gives up any gain if sterling falls and the bank only waives the failure loss. Here the contingent forward costs 2.00 million euros if the deal completes and nothing otherwise, while an at-the-forward call at 8 per cent volatility costs 5.18 million upfront in every case. The option keeps the benefit if sterling falls: 220.46 million instead of 233.71.
The amount actually payable in the foreign currency at completion, after net debt, debt-like items and the estimated working capital adjustment, plus any debt the buyer refinances in that currency. Each 0.0100 move on GBP 200.0 million is 2.00 million euros, so hedging the headline instead of the cash payable leaves a real open position.
This article is one calculation from Closing the Deal. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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