Over the past 3 months the rand has weakened against the dollar by almost 10%, and around 6% over the last month alone. There are many importers who are crying and exporters who are smiling.

But what if for example you are an exporter with orders or work-in-progress that will only be shipped, and foreign currency proceeds received in 9 months’ time. This could typically apply to a citrus producer. By the time the foreign currency arrives in your bank account the exchange rate could be in a very different place. Human nature would dictate that you don’t want to receive lower than the current rate but would love to receive a higher rate if the rand weakens further. In other words, you want to limit the downside but keep your upside options open.

As it happens, there is a financial instrument available to satisfy this desire. It’s called an export put option. A put option (or “put”) is a contract giving the option buyer the right, but not the obligation, to sell a specified amount of foreign currency at a predetermined price at a specific date. This predetermined price at which the buyer of the put option can sell the foreign currency is called the strike rate.¹ The exporter will have to pay an upfront premium to the bank for this option. The premium amount payable will be affected by changes in the exchange rate, the chosen strike price, interest rates, and the exchange rate volatility.

An alternative strategy would be to simply purchase a forward exchange contract (FEC) to sell US dollars in 9 months’ time at the current forward exchange rate, comprising the current spot rate plus forward points (the interest rate differential between the two currencies). For a more detailed explanation of how an FEC works, see our previous article here.

The key assessment that needs to be done is the value of the certainty of an FEC versus the potential net additional upside of a put option.

Let’s look at a real-life example, based on an actual quote from a major South African bank during the past 2 weeks. We’ll look at three alternative strike rates.

To determine the effective rate achieved should the rand strengthen, resulting in the option being exercised, the premium must be subtracted from the strike rate. So, with a R17.00 strike rate less the 4.87% premium, the resulting effective rate achieved will be R16.17. Compare this the certain R17.38 achieved by simply entering into an FEC.

But what if the rand weakens further than where it is currently trading?

The table below shows the rate achieved net of premium at different market spot rates. This would be where the market rate at the time of expiry of the option is above the strike rate and therefore one would let the option lapse, having paid the premium and execute at the prevailing spot rate.

This demonstrates that with a R17.00 strike rate the market rate at time of execution would need to be between R18.20 and R18.30 to provide a better result than a forward exchange contract. That amounts to a further depreciation of 7% over the next 9 months.

The chart below illustrates these options’ possible “pay-off” curves from a spot rate of R16.00 through to R18.60 against the certain “pay-off” from a simple forward exchange contract.

Let’s assume the exporter had done their costing and revenue forecasting 3 months ago and been satisfied that the resulting margin would be sustainable for their business. The prospect of being able to secure their revenue at such a premium must be pleasing.
The question is how much more upside do you “need” to capture, that might never happen, at a cost that could reduce your result by more than R1.00 relative to the certainty and forward points return of an FEC. Every business is unique and so some might choose to follow this currency options strategy, while others will prefer to bank their gains and remove any further uncertainty.

There certainly is a place for currency options and there are other option instruments and strategies available to manage your foreign exchange risk. We will be discussing them in future articles, but it is very important to stress that the process of assessing what foreign exchange instruments to use must form part of a well thought out and thoroughly researched foreign exchange risk management policy.

References:

1. https://www.investopedia.com/terms/p/putoption.asp (adapted)