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Forward exchange contracts

Companies involved in international trade can be seriously affected by adversely moving exchange rates. A forward exchange contract is an effective hedging mechanism similar to an insurance policy, as it protects a trader from unfavourable exchange rate movements.
However, it precludes the trader from profiting from a favourable movement in the currencys exchange rate. The transaction is permitted in terms of the Exchange Control Rulings or a specific authority has been granted by the authorities for the transaction The period of cover does not exceed 12 months at a time The commitment is not already covered Documentary evidence of the commitment presented to the bank within 14 days of establishment of the FEC.

Definition
A forward exchange contract, commonly known as FEC or forward cover, may be defined as a contract between a bank and its customer whereby a rate of exchange is fixed immediately for the purchase (or sale) of one currency for another, or for delivery at an agreed future date. Forward exchange contract rates are based on interest differentials between the countries concerned, and are not predictions of what the rates of exchange will be in the future. Note: While the rate of exchange is fixed when the contract is entered into, value (money) only changes hands at the maturity date.

Foreign currency contracts


In the international foreign exchange markets, the values of the various local currencies are expressed by indicating the price of one US dollar in local currency. To calculate and quote a rand/foreign currency exchange rate, a South African bank will use the rand/dollar rate, and the dollar/ foreign currency rate. In view of this there are two distinct legs (transactions) in any rand/foreign currency deal. To calculate a forward exchange rate for such transactions, the interest differentials must be taken into account for both legs (transactions).

Premium and discount


The interest rate differential between two countries could either be at a premium or a discount. When the foreign interest rate is higher than the South African interest rate, the foreign currency is at a discount. The forward rate is then lower than the spot rate which will benefit the importer but will be at a cost to the exporter. Conversely, when the foreign interest rate is lower than the South African interest rate, the foreign currency is termed to be at a premium. The forward rate is then higher than the spot rate and will benefit the exporter but will be at a cost to the importer.

Exchange control requirements


The South African exchange control authorities allow banks to enter into FECs subject to the following conditions: A firm and ascertainable foreign exchange commitment must exist for example, a commitment to pay for imports

Establishment
Application for a forward contract must be made to any International Trade Services front office. As a forward contract represents a contingent liability, the branch manager who will apply the normal credit criteria when assessing the request must sanction it. Once the facility has been granted and limits set in place, the applicant will be required to complete a form
1

covering the general conditions applicable to forward exchange contracts. The general conditions form is valid for a period of 10 years, and needs to be renewed thereafter. A customer wanting to enter into a forward exchange contract must state what type of contract is required, and what type of cover is needed.

FEC contracts
The following contracts are available: 1. Fixed contract: a specific delivery date is agreed upon. The delivery of the foreign currency at the rate fixed in the FEC will be made on the exact date (fixed date) specified in the contract.
non-optional period

opening date

maturity date

2. Partially optional contract: this contract is fixed during the first period (from opening to option start date) and then fully optional from option start date to due/maturity date. The delivery of the foreign currency at the forward contract rate can take place at any time during the optional period.
non-optional period fully-optional period

opening date

fixed date

maturity date

3. Fully optional contract: the delivery of the foreign currency can take place at the forward contract rate at any time throughout the entire existence of the FEC.
fully-optional period

opening date

maturity date

Types of cover
The importer/exporter can cover either one of the two legs of the transaction, or both of them, depending on his view of the currency market. He can opt for: Foreign currency/dollar cover thereby leaving the rand/dollar leg uncovered; Rand/dollar cover thereby leaving the foreign currency/dollar leg uncovered; or Rand/foreign currency cover thereby eliminating the entire currency risk.

Deliveries
Where a commitment is to be paid, the importer must give full details of the payment and advise the bank in writing to use the relevant contract. The bank requires two business days notice in order to make the payment and will convert the foreign currency at the applicable forward contract rate. Should the amount to be received or paid exceed that available under the contract the difference can be converted at a spot (current) rate of exchange. Note: Should payment instructions not be received by or within two days after the maturity date, the contract will automatically be extended for a further two weeks at a cost to the client.

contract remains unused and is surplus to requirements. To eliminate the surplus funds the bank enters into a contra (swap) contract to buy back (offset) the amount on the maturity date of the original contract.

exchange on which the original contract is based.

Surrender
In the event of an importer being unable to use his forward exchange contract, in whole or in part, the outstanding balance is surrendered by settlement for the difference in exchange between: The forward contract rate, and The current days spot telegraphic buying rate of exchange.

Extensions
On occasions, payment is delayed owing to late arrival of documents or other mishaps. In such cases the maturity date of the forward contract may be extended and this is done by means of a swap. The importer must fulfil his obligation under the existing contract, that is, he will receive the foreign currency against settlement in rand at the forward contract rate. As the importer has no foreign currency commitment at this time, he must sell the foreign currency to the bank at the spot (current) rate of exchange. At the same time and based on the same spot rate the bank will provide a fresh forward contract to the new maturity date. Note: 1.The difference in exchange between buying the foreign currency at the forward contract rate and selling the foreign currency at the spot rate of exchange is not a profit or loss in exchange, but is merely a prepayment to or an advance by the bank. 2. The importer does not lose the benefit of the rate of

Advantages
Forward exchange contracts offer the following advantages: The company is protected against exchange rate fluctuations. The exact value of the export and import order can be calculated on the day it is processed. Budgeting and costing are accurate.

Early deliveries
Early deliveries under a forward exchange contract are deliveries requested: before the maturity date of a fixed contract, or during the fixed period of a partially optional contract. Early deliveries under a forward exchange contract are done on a swap basis. For example, the importer needs to effect a payment during the fixed period of the forward exchange contract. He is unable to use the contract owing to the fixed period and to assist him the bank will provide the foreign currency converted at the current ruling rate of exchange. The forward

Disadvantage
Exchange rate fluctuations. Once a company has covered a transaction with a forward exchange contract, it cannot take advantage of favourable exchange rate movements.

Cancellation of commitment
If an order is cancelled the forward exchange contract may be utilised for another commitment or can be surrendered at the prevailing spot exchange rate, which can result in a financial loss/profit.

Administrative burden
Early deliveries, extensions, surrenders and cancellations during the fixed period of a forward exchange contract are done on a swap basis causing additional administration.

Conclusion
For further information on any of our products and services, please contact your nearest International Trade Services office, visit our website at www.standardbank.co.za (select Corporate and Investment, click on Banking/Finance solutions and go to International Trade Services), or call 0860iTrade 0860 487 233.

The Standard Bank of South Africa Limited (SBSA) has made every effort to ensure the accuracy and completeness of the information contained in this document. The information is not intended as advice and no warranty express or implied is made as to the accuracy, correctness or completeness of the information, which is subject to change at any time after publication without notice. Should the information lead you to consider entering into any transaction in relation to a financial product (the product) you must take note of the following: There are intrinsic risks involved in transacting in any products. No guarantee is provided for the investment value in a product. Any forecasts based on hypothetical data are not guaranteed and are for illustrative purposes only. Returns may vary as a result of their dependence on the performance of underlying assets and other variable market factors. Past performances are not necessarily indicative of future performances. Unless a financial needs analysis has been conducted to assess the appropriateness of the product, investment or structure to your unique particular circumstances, SBSA cautions you that there may be limitations on the appropriateness of the information for your purposes and you should take particular care to consider the implications of entering into the transaction, either on your own or with the assistance of an investment professional. There may be various tax implications to consider when investing in the product and you must be aware of these implications before investing. SBSA does not accept liability for the tax treatment by any court or by any authorities in any jurisdiction in relation to any transaction based on the information. It is strongly recommended that individual tax advice be sought before entering into any such transaction. Authorised financial services provider The Standard Bank of South Africa Limited (Reg. No. 1962/000738/06). SBSA 804700 03/06

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