Variable Prepaid Forward Contracts

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on September 07, 2023

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What Are Variable Prepaid Forward Contracts?

Variable prepaid forward contracts are financial derivatives that allow an owner of an asset, typically a large stockholder, to receive a percentage of the current value of their asset immediately while deferring the decision to sell and the subsequent tax consequences.

Essentially, it is a contract between two parties: the owner of an asset and an investor, typically a financial institution. The asset owner agrees to sell the asset at a future date for a price within a range determined by the contract.

The purpose of these contracts is to help asset owners access liquidity and manage risk. Key features include the upfront cash payment, the variable delivery obligation based on the contract's terms, and the deferral of tax consequences.

The variable delivery feature allows the asset owner to deliver varying amounts of the asset at maturity based on the asset's price.

Mechanics of Variable Prepaid Forward Contracts

Parties Involved

Two parties are involved in a variable prepaid forward contract: the asset owner, also known as the holder or seller, and the investor, typically a financial institution or bank.

Contract Terms and Conditions

Prepaid Amount

The prepaid amount refers to the initial cash payment made by the investor to the asset owner. This amount is typically a percentage of the current market value of the assets covered by the contract.

Forward Price

The forward price is the range of prices at which the asset might be sold. This price is set at the contract's inception and is based on the expected future value of the asset.

Term or Maturity

The term or maturity of the contract is the predetermined period after which the contract expires. At this point, the asset owner must deliver a certain number of shares or the cash equivalent.

Participation Rate

The participation rate in a variable prepaid forward contract refers to the proportion of the asset's future appreciation that the asset owner retains.

Dividend Treatment

Dividend treatment is a crucial aspect of these contracts, as the asset owner retains the dividends during the contract period.

Settlement Methods

Upon the contract's maturity, it can be settled by delivering the assets, delivering a cash equivalent, or rolling over the contract.

Benefits and Risks of Variable Prepaid Forward Contracts

Benefits

Customization and Flexibility

Variable prepaid forward contracts can be tailored to fit an individual's or institution's specific financial and risk management needs. This level of customization allows for considerable flexibility.

Capital Preservation

These contracts allow asset owners to generate liquidity without an outright sale, helping preserve capital and defer capital gains tax.

Enhanced Returns

Variable prepaid forward contracts can enhance returns by allowing the asset owner to receive an upfront payment while still participating in potential asset appreciation.

Risks

Market Risk

Market risk involves the potential asset value decline during the contract term.

Counterparty Risk

Counterparty risk is when the financial institution or investor fails to fulfill their contractual obligations.

Liquidity Risk

Liquidity risk in variable prepaid forward contracts arises from the contract’s obligation to deliver assets or cash at maturity.

Credit Risk

The credit risk is the risk of default by the investor, which could result in financial loss to the asset owner.

Benefits and Risks of Variable Prepaid Forward Contracts

Accounting and Tax Considerations for Variable Prepaid Forward Contracts

Accounting Treatment

Under Generally Accepted Accounting Principles (GAAP), variable prepaid forward contracts are typically considered derivative instruments, requiring mark-to-market accounting.

Tax Implications

The tax implications of variable prepaid forward contracts can be complex. The initial prepaid amount may not be taxable, and tax on the capital gain from the future sale can be deferred until the contract’s maturity.

Applications of Variable Prepaid Forward Contracts

Hedging Strategies

Variable prepaid forward contracts can be used as a hedging strategy to protect against potential future losses in the value of an asset. The asset owner can limit their downside risk by setting a range for the future sale price.

Leveraged Investments

These contracts can be used to leverage an asset owner's position. The upfront cash payment can be reinvested, potentially increasing overall returns.

Tax Planning

A key application of variable prepaid forward contracts is in tax planning. The deferral of capital gains tax can provide significant tax advantages for asset owners.

Estate Planning

In estate planning, these contracts can provide liquidity for estate taxes without requiring the asset's sale, helping maintain the estate's value.

Applications of Variable Prepaid Forward Contracts

Comparison With Other Financial Instruments

Options

Unlike options, variable prepaid forward contracts require an obligation to sell the asset at maturity, whereas options provide the right but not the obligation to buy or sell.

Futures Contracts

Unlike futures contracts, which require the delivery of a fixed amount of an asset, variable prepaid forward contracts involve a variable delivery amount based on the asset's price at contract maturity.

Swaps

While swaps involve the exchange of cash flows, variable prepaid forward contracts involve the potential sale of an asset at a future date.

Exchange-Traded Funds (ETFs)

Unlike ETFs, which are investment funds traded on stock exchanges, variable prepaid forward contracts are private agreements between two parties.

Regulatory and Legal Considerations

Securities Regulations

Variable prepaid forward contracts are subject to securities regulations. For instance, in the US, the Securities and Exchange Commission (SEC) has rules and guidelines for these contracts.

Disclosure Requirements

There are specific disclosure requirements for public companies and large shareholders using variable prepaid forward contracts.

Investor Suitability

Given their complexity and risks, these contracts are typically suitable for sophisticated investors with a high-risk tolerance.

Conclusion

Variable prepaid forward contracts are complex financial derivatives that allow asset owners to receive an upfront payment, participate in potential future asset appreciation, and defer the tax consequences of a sale.

These contracts offer several benefits: liquidity, risk management, tax deferral, and potential return enhancement. However, they also carry market, counterparty, liquidity, and credit risks.

Investors considering these contracts should understand their complexities, potential benefits, and risks. They should also consider their financial situation, risk tolerance, and investment objectives.

The future of variable prepaid forward contracts looks promising, with increasing market adoption and innovations. However, potential challenges include regulatory changes and market volatility.

Variable Prepaid Forward Contracts FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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