|Exporter X received an order of USD 100 000 for his products in July 2009 when the USD/ZAR exchange rate was trading at around ZAR8.30/USD. He worked out that he would be receiving R830 000 in three months time when his customer paid him. He took the view that with the rand mostly weakening, he might even get more rands by that time, which could assist him to make a slightly higher margin on his competitively priced products.
His view on the currency market was in fact incorrect (surprise, surprise) and the rand started strengthening. He kept on hoping that the rand would weaken again very soon, and that all would work out as planned. As he was not sure of the exact date he would receive the dollars, he also thought that he would just wait until the dollars arrived by when the rand would hopefully have moved in his favour.
The dollars eventually arrived after more than three months and the bank converted it at a rate of R7.30/USD. Exporter X, who expected to receive R830 000, now received only R730 000. He was down R100 000 on the deal just because of the exchange rate movement, which was more than the profit margin that he had built into his price! He thus made a serious loss on the consignment. In fact, for every one dollar value of the contract he lost one rand.
As you can see from the above case study, the exporter clearly did no risk management and left a lot to chance (he was probably not aware how it would work). More importantly, he did not hedge or protect his forex exposure. By doing nothing he has in fact taken a bet on the currency market (knowingly or unknowingly) and as a result, incurred a huge loss.
The correct procedure for the exporter should have been to have hedged his exposure in July already (on the day that he received the order) and to sell the dollars 3-months forward. By selling forward, he is getting a guaranteed promise from a buyer to buy the dollars from him at some future date but at an agreed upon exchange rate set today. Of course, the forward rate that the two parties agree to will be different from the spot rate (the current rate today) and the premium or discount represents the cost of obtaining such protection. The value of a forward contract is that your future income (in rands) is guaranteed. If he had sold his dollars forward on that day he would have also have received a premium as a result of interest earned and could have received at least an additional 10 SA cents/dollar, as the interest differentials between the dollar and the rand would have worked in his favour.
The reality is that instead of receiving R 840 000, (R8.30 plus 10c for selling forward) he has only received R730 000 (R110 000 less) – in reality an even bigger loss because of poor risk management.
So what should you do? The world of forex is complicated and it requires expert advice. There are specialists in this field and you should definitely consult them. Of course, your bank can also assist you, but there are private sector forex experts that act as intermediaries and that will work on your behalf to get you better exchange rates from the bank and to advise you how best to minimise your risks, as well as highlighting the process and the pitfalls. They’ll also help you get your timing right. By putting their expertise to work for you, you can protect yourself against forex risk, get better forex rates, and maybe even earn a bit of extra money on your (protected or hedged) exposure.
Written by Mario Moschetta
Change Financial Services