Our FX team recently published an article titled, “The Rand: Navigating Uncertainty.” Once again, I was struck by the sheer extent of the uncertainty businesses are facing – increased volatility, geopolitical tensions, trade disruptions, climate-related headwinds (particularly in the agricultural sector), and the list goes on.

In this environment, uncertainty is no longer an occasional disruption for many businesses, it has become a constant part of operating and planning.

For those with cross-border exposure, this makes managing currency risk not just important, but increasingly essential.

South Africans are resilient. Despite the many challenges businesses face, they continue to push forward, innovate, adapt, and, at times, simply persevere to survive.

For many businesses, expanding into international markets and/or sourcing products from abroad has become essential. Crossing borders through imports and exports creates opportunity. That said, currency movements introduce risks that require careful management and consideration.

Over the years, many businesses have asked the same question: do I need to hedge my position? Some operate with firm hedging policies in place; others do not.

The reality is that businesses are moving beyond relying solely on spot transactions and are increasingly making use of Forward Exchange Contracts (FECs).

In my experience, both have an important role to play in a robust FX management strategy.

Spot transactions involve buying or selling currency for immediate delivery.

A spot transaction is an agreement to buy or sell currency at the current market rate, with delivery and payment taking place immediately or within the standard settlement period of one to two business days.

While spot transactions certainly have their place, the context of the underlying trade should always be considered. Where a business has a future foreign currency commitment to pay (importer) or expects to receive foreign currency at a later date (exporter), the rand outcome remains uncertain. In these cases, the spot market leaves the business exposed to unpredictable exchange rate movements until payment is made or funds are received.

Forward Exchange Contracts (FECs) enable a business to secure an exchange rate today for a future foreign currency payment or receipt.

In a forward transaction, the terms of the purchase or sale are agreed upfront, while settlement takes place at a future date. In other words, the exchange rate is fixed now for a future exchange of currencies.

FEC rate methodology:

FEC rates are calculated using the current spot rate, adjusted for the interest rate differential between the two countries concerned. They are not a prediction of where the exchange rate will trade in the future. For example:

• SA company importing – payment in USD:
  • Interest rates in the US are currently lower than those in South Africa. The net difference (premium) is added to the spot rate, resulting in an FEC rate that is higher than the current spot rate. While this makes the forward rate more expensive than spot, it protects the business against market volatility.
• SA company exporting – receiving USD:
  • Interest rates in the US are currently lower than those in South Africa. The net difference (discount) is applied to the spot rate, resulting in an FEC rate that is higher than the current spot rate. This gives the exporter a more favourable rate and secures the exchange rate for when the funds are received and converted into ZAR.

Dealing with unexpected delays and changes to expected payment/receipt dates:

• As mentioned, FECs are fixed for a future date. If there is a delay or the required date changes, an FEC can be brought forward (early drawdown) or extended to a different date. It is important to bear in mind that these changes may result in cash flows.

Cash Flow for drawing down early on a FEC?

Early deliveries on FECs can have cash flow implications, particularly where an importer needs to settle a supplier earlier than originally planned, or where an exporter receives funds ahead of schedule.

Where an FEC is drawn down earlier than the original maturity date, the contract does not fall away and the exchange rate protection remains intact. What changes is the effective period of the FEC. Because the contract is now in place for fewer days than initially agreed, the interest component built into the forward rate must be adjusted accordingly:

• Importer receives back the forward points relating to the period by which the contract has been shortened.
• Exporter will give back the forward points relating to the period by which the contract has been shortened.

From a business perspective, the important point is that early delivery may affect short-term cash flow, but it does not change the purpose of the hedge. The FEC still provides protection against adverse exchange rate movements. What changes is simply the interest adjustment linked to the revised timing.

Cash Flow vs Profit/Loss for extending a FEC?

When speaking to clients, a question that often arises is: “There has been a delay in shipment. I need to extend my FEC. Will I make a profit or a loss?”

Where an FEC needs to be extended to a later date, a cash flow adjustment will apply. This is not a profit or loss. The cash flow arises from the additional interest associated with the longer period:

• Importer pays interest (premium) for the additional days
• Exporter receives interest (discount) for the additional days

This principle applies to both extensions and early drawdowns. In simple terms, the importer pays the premium for the effective period of the FEC, while the exporter receives the discount for the effective period of the FEC.

In Closing

FECs offer exchange rate protection while also bringing greater stability to cash flow. They support more predictable costs, easier pricing decisions, greater confidence in profit margins, protection against adverse market movements, and improved long-term planning.

A robust FX hedging strategy will usually include a combination of spot transactions and FECs.

Protect and strengthen your cash flow with an FX hedging strategy tailored to your business, able to evolve with it, and designed to reduce the uncertainty created by external market shocks.

If you are keen to assume control, arm yourself with a strong FX hedging strategy and have an edge on your competitors, please reach out:
Jacky Buys at jbuys@wauko.com or 021 819 7829.