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FX Hedging - Forward Exchange Contracts for Individuals

Forward Exchange Contracts, otherwise known as Forward Cover, is a product frequently used by business entities to secure an exchange rate today, for settlement sometime in the future and are typically used to 'hedge' a direct underlying foreign currency exposure, in respect of periods less than 12 months, or a firm and ascertained commitment for periods more than 12 months.

By the way, a ‘hedging’ arrangement, basically means the implementation of a risk management strategy designed to limit losses which might occur because of price changes in future foreign exchange commitments and the likes.

A business will often approach their Bank if they are concerned that the Rand/Foreign Exchange rate might not be advantageous at a time in the future when they are required to make or receive a foreign currency payment, e.g., an import payment or an export receipt. The Forward Cover product enables the contracting party to offset or limit losses caused by fluctuations in the price of currencies and offers a business the opportunity of fixing an exchange rate immediately, for a future foreign commitment or receipt. This will allow them to know at an early date how much their currency transaction will cost and will equally enable them to optimally price their products, upon eventual sale to customers.

However, did you know that a simple hedging product such as a Forward Exchange Contract can also be used by private individuals!

It is fair to say that a private individual will similarly have some relatively high valued future firm foreign exchange commitments, or for that matter, just a probable foreign exchange commitment, where just like a business enterprise, exchange rate fluctuations could be responsible for an unexpected change in the price of foreign currency over time, resulting in an additional cost to you.

These ‘Forward Cover’ arrangements can be used to ‘hedge’ a direct underlying foreign currency exposure, in respect of periods less than 12 months, which is generally known as Active Currency Management (ACM), or a firm and ascertained commitment for periods more than 12 months. It does need to be recognised, however that these Forward Exchange Contracts are not a ‘tool’ to facilitate speculative practices and before establishing a Contract with your Bank, you will need to be of a view that in respect of foreign currency commitments for a maximum of 12 months, there will be reasonable intention to pay away or receive foreign currency within the period of the underlying ‘Contract’. Any documents which support the foreign currency commitment in respect of contract periods less than 12 months only need to be presented to your Bank, at the conclusion of the contract which would be the time when foreign exchange will be paid away.

For those contracts which extend beyond 12 months, documentation to support a fixed commitment must be presented to your Bank within a period of 14 days after the contract has been established.

Since Banks will charge a fee for providing the ‘Forward Cover’ product and in some cases will ask for a reimbursable deposit known as a ‘margin’ payment, it goes without saying that financial benefits can only really be derived in respect of covering forward high value foreign currency transactions, such as an expensive import or even your R10Million Foreign Investment Allowance (FIA) and annual Single Discretionary Allowance (SDA) of R1Million.

In the case of covering forward your Foreign Investment Allowance (FIA), it is quite possible you will know that you wish to make the investment offshore, within a period of 12 months, but currently the money which you might wish to use to fund the transfer is still invested in a local instrument or product, which will only mature in say, eight months. You might also be worried that the cost of currency could rise over the period in question. It is therefore quite feasible to approach your Bank at an earlier point to acquire a Forward Exchange Contract, which will enable you to fix the price of the currency eight months ahead of when you wish to transfer into your intended offshore investmeYou will then know immediately how much the currency will cost you at the time of settlement of the Contract which would be when the physical transfer of funds occurs. Only at the time currency is to be transferred, would the Bank ask you for your TCS PIN Letter from SARS to verify that there was indeed a reason to acquire the currency. It should of course be understood that these arrangements only apply where the term of the contract does not exceed 12 months. In respect of Contracts for periods exceeding 12 months, you will be asked for supporting documentation within a period of 14 days from when the contact was established to verify the commitment, failing which the contract would typically be cancelled by the Bank, which may or may not result in a cost to you.

It is relevant to note that in the case of the Foreign Investment Allowance and Single Discretionary Allowances, these are deemed to be applicable and valid for a Calendar year in terms of Financial Surveillance principles. However, in respect of the FIA which requires a TCS PIN Letter issued by SARS, these letters are regarded as valid for any 12-month period. It would therefore be feasible for you to acquire a Forward Exchange Contract from your Bank, in the year prior to remitting your allowances, assuming of course that the Contract is acquired in terms of ACM principles, i.e., up to a term not exceeding 12 months. Your SDA which does not require the issue of a TCS PIN Letter from SARS, can be similarly ‘hedged’ over a term not exceeding 12 months.

I think it is important to conclude this ‘piece’ with a reminder that the Forward Cover product is designed to, inter alia, help you manage costs relative to the purchase or sale of foreign currency which you believe you will encounter at a date in the future. It is not a product to be used for speculative purposes, which would be very much frowned upon.

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