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Forward Foreign Exchange Contracts

Forward Foreign Exchange Contracts. Forward Foreign Exchange Contracts. 1. What is an FEC 2. How is an FEC rate calculated 3. Early delivery under an FEC 4. Extension of an FEC 5. Cancellation of an FEC 6. Factors involved in quoting a price to a client

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Forward Foreign Exchange Contracts

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  1. Forward Foreign Exchange Contracts

  2. Forward Foreign Exchange Contracts 1. What is an FEC 2. How is an FEC rate calculated 3. Early delivery under an FEC 4. Extension of an FEC 5. Cancellation of an FEC 6. Factors involved in quoting a price to a client 7. Pricing applicable to FEC’s 8. Formalities 9. Conclusion - Questions

  3. Definition • A forward foreign exchange contract (FEC) is an agreement to exchange one currency for another at a fixed rate on a specified date in the future • The FEC fixes the price of foreign currency payments or receipts expected to materialise at a future date • It eliminates adverse currency movements beyond the agreed forward rate

  4. Cost / Benefit Calculations A South African importer expects to receive goods, payable in Dollars, in six months’ time. The company decides to cover an expected depreciation of the Rand by taking out an FEC contract. The six-month $/R FEC rate is 8,3295. The opportunity cost / benefit after six months is: SPOT 8,0000 8,5000 FEC 8,3295 8,3295 0,3295cost0,1705benefit

  5. Advantages • Protection from unfavourable movements in future spot rates • Future cash flows certain and predictable • Flexibility resulting from the availability of early drawdowns, extensions and cancellations • Amounts and delivery dates tailored to meet requirements • No upfront costs

  6. Disadvantages • No opportunity to benefit from future spot rates more favourable than the FEC rate • Potential negative cash flow if transaction takes place on a date different to the agreed date • Exchange rate risk if original/underlying commitment cancelled

  7. When to Use • Use FEC if you believe the currency will move substantially against the underlying position • Leave the transaction open if you believe the currency will move favourably to the underlying position • Use FEC if the policy is to hedge target returns or meet budgeted rates: lock-in profit margin

  8. South African Market Characteristics • Exchange Controls: Cover can be taken on any firm and ascertainable commitment/receipt • Lack of Liquidity at times can lead to huge price fluctuations

  9. Pricing of FECsShort-term forward rate formula Where rD = domestic interest rate rF = foreign interest rate t = days in forward period y1 = days in domestic interest year y2 = days in foreign interest year

  10. Pricing Dollar/Rand FECs: Example • Six month (182 days) hedge • Spot: R8,00 • S.A. 182-day interest rate: 11% (365 day rate) • U.S. 182 day interest rate: 6% (360 day rate) • Forward = R8,2713 • Market rate will differ from theoretical rate because of transaction costs and risks, e.g. liquidity, counterparty

  11. Early Drawdowns • Used when payments are made/received before the FEC expires • Involves buying/selling at the current spot rate andsimultaneouslycancelling the existing FEC. How? • By selling/buying another FEC for the same maturity date to the bank • Known as a Swap transaction • Always involves a cash flow at the maturity of the original FEC

  12. Early Drawdown: Example Importer Original FEC USD 100 000 Forward Rate R 7.20 due in 3 months Spot 1 m 2 m 3 m Drawdown after two months Spot rate at drawdown: R 8,2500 1 m Forward rate at drawdown: R8,3000 Note:Bank buys and sells at same spot rate and calculates forward rate for remaining one month

  13. Early Drawdown Example: Result Leg 1 Rand Cost R820 000 Original FEC: R8 2000 Client buys dollars at current spot rate: R8 2500 R825 000 R5 000 Net: The client will pay R5 000 more than anticipated. This is a negative cash flow rather than a loss Leg 2 Cancellation of the FEC Client bought dollars forward at original rate at rate of R8 2000 R820 000 Now sells dollars back to the bank at current forward rate for one month of R8 3000 R830 000 R10 000 Benefit to client Net benefit to client: R5 000

  14. Extensions • If you have not received your goods or documents and are unable to take delivery of the forward contract, you can extend the contract. How? • By cancelling the existing contract and simultaneously taking out a new contract for the additional period • Known as Swap transactions • Cash flows on extensions occur on the date that the original FEC matures

  15. Extensions: Example Importer Original FEC: $100 000 at 8 2000 When the FEC matures there is a need to extend for a further two months Leg1 Original FEC $100 000 at R8 20 R820 000 Bank repurchases FEC at the current spot rate at R8 25 R825 000 Client has a positive cash flow on original maturity date: R5 000 But needs to re-establish cover with a new FEC for two months

  16. Extensions: Example Leg 2 New FEC at current spot of R8 2500 plus forward points of 0,0900 = R8 3400 Rand payment on new FEC of $100 000: R834 000 Original FEC at R8 20: R820 000 Difference: R 14 000 On maturity client pays R15 000 more Overall result At spot: benefit to client: R15 000 At final maturity: cost to client R14 000 Overall cost to extend: R 9 000

  17. Cancellations • Order cancelled • No fixed commitment • Can cancel at: spot or forward • cash flow implications

  18. Cancellation: Example • An importer buys a FEC amounting to USD 100 000 for three months at R8 20 • Expected rand payable is R820 000 • On maturity the client wishes to cancel • The Bank will buy the contract from the client at the current spot rate of R8 40

  19. Example (continued) Net Result Client bought $100 000 at R8 20 and pays Bank R820 000 Client sells $100 000 at R8 40 and receives R840 000Benefit to client R 20 000 If the client was an exporter this would be a loss

  20. Impact of Swap Transactions on Facilities • All negative cash flows on early drawdowns are marked fully against your facility. They are however netted off against positive cash flows accruing • Extensions: 10% notional against new rand value • Forward cancellations: full cost of cost/benefit at maturity

  21. Types of FECs • Fixed maturity date • Optional Forwards • Partially Optional Forwards

  22. Factors Effecting Prices Quoted • The size of the transaction. The smaller the amount the less attractive the price • Volatility in the market at the time • Credit risk

  23. Pricing applicable to FEC’s • Establishment cost R75.00 per FEC • Drawdown cost R75.00 per drawdown • Cancellation Cost R75.00 per cancellation • Extension cost R75.00 per extension

  24. Formalities • A pro forma invoice needs to be supplied at time of establishing FEC • A credit line needs to be in place • Two days prior to payment bank requires documentation, payment instructions and BOP customer application to buy foreign exchange • The bank will confirm the FEC at time of establishment and customer to confirm back. This confirmation could be by e-mail as well

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