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
currency’s exchange rate.
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.
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
• 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.
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.
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
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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
opening date
maturity date
period
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.
opening date
non-optional
period
fixed date
fully-optional
period
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.
opening date
fully-optional
period
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.
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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.
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.
Extensions
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.
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.
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
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
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.
Early deliveries
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 day’s spot
telegraphic buying rate of
exchange.
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.
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.
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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.
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Authorised financial services provider
The Standard Bank of South Africa Limited (Reg. No. 1962/000738/06). SBSA 804700 03/06
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