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South Africa: Major Step Forward for Local Financial Markets
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Business Day (Johannesburg)
5 May 2008
Posted to the web 5 May 2008
Edward Adcock
Johannesburg
THE JSE's rand futures market will be opened up, Finance Minister Trevor Manual announced in his Budget speech on February 20.
With these few words he opened up a huge market previously only available to a few select institutions. Now all corporate entities -- including trusts, close corporations, private companies and partnerships -- will be able to trade in currency futures, with no restrictions on the value traded.
But what are currency futures, and where do they fit into financial markets? Currency futures are agreements between two parties, where one commits to buy (go long) a currency and another to sell (short) a currency on a specified future date. (A long currency future holder is long the US dollar and short the rand. A short currency future holder is short the dollar and long the rand.)
Now that the market has been opened up, currency futures will begin to compete with the existing over-the-counter forward market, as although both products allow investors to successfully hedge against currency risk, currency futures give the client more freedom of choice. Corporates do not need permission to trade currency futures, nor do they have to report their currency future trades to the South African Reserve Bank.
Currency futures are standardised JSE (Yield-X) exchange products, ensuring transparency and liquidity for the client. This represents a major step forward for South African financial markets. They are used primarily to hedge (remove) the risk of existing or expected currency exposure, or speculate when the belief is that currency rates will change
The following example of the use of currency futures as a hedge could apply to an exporter:
The exporter receives an order to export goods to the value of $10000. He shorts 10 currency future contracts at R8,20 to the dollar, an exposure of R82000, and an amount of R3100 is deposited for the initial margin.
If the rand strengthens to R8,15 or below a profit is made on the contracts, which offsets the loss on the physical dollar exchange. (Locked in at R8,20) If the rand weakens to R8,25 or above a loss is made on the contracts but a profit is made on the physical dollars exchange and these offset each other (locked in at R8,20).
Zero sum (no profit, no loss); position is hedged.
For the importer: An importer orders goods from the US valued at $10000 to be received in about four months. He goes long 10 currency future contracts at R8,20, an exposure of R82000, and deposits R3100 for the initial margin.
If the rand strengthens to R8,15 or below a loss is made on the contracts that offsets the profit made on the physical dollars. (Locked in at R8,20). If the rand weakens to R8,25 or above a profit is made on the contracts but a loss is made on the physical dollar exchange and they again offset each other (Locked in at R8,20).
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Zero Sum (no profit, no loss); position is hedged.
If a speculator expects the rand to fall against the dollar, he could buy 10 contracts at R8,20, an exposure of R82000, and deposit R3100 for the initial margin. If he sells the contracts at R8,55 he makes a profit of R3500 (10 x $1000 x {R8,55-R8,20}). The initial margin of R3100 is returned, so the initial capital outlay returns R3500, a return of 113% during a period in which the rand fell 4%.
Edward Adcock is a derivative trader at Equity Derivative Investments, a registered member of Yield-X.
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