The market in forex options is experiencing tremendous growth that could continue in the years ahead. In the relatively short space of five years, the South African forex-option market has made the kind of progress that took overseas financial markets a lot longer to achieve.
We’ve come a long way since the forerunners of today’s FirstRand Banking Group pioneered currency option development in South Africa in the late 1980s.
Today, the market offers a plethora of forex options ranging from vanilla puts to more advanced exotic options, many of which have colourful industry-specific names — including seagulls, shark fins, cable cars and wedding cakes.
Transaction sizes vary from $10 000 to more than $100-million. Companies from all industry sectors use these options — from restaurants and mines to retail stores and banks.
The main reason for the growth has been the volatility of the rand. Prior to 2000, our depreciating currency was largely seen as a one-way bet. Since then, it has experienced huge swings in value, from more than R13 to the dollar to less than R6.
With that kind of volatility, importers and exporters have faced increasing pressure to guard against the currency moving the wrong way. Even a 10c shift either way in the exchange rate can make a huge difference to a $10-million transaction.
Other factors pushing companies towards greater use of forex options are greater awareness and financial literacy, and a desire for more financially flexible alternatives in the way they hedge their forex risk — and options provide just such flexibility.
Accounting standards have also changed in such a way that companies are able to account for forex options in ways that are favourable to their income statements.
On a broader level, the increasing shift towards stricter corporate governance — particularly after the Enron disaster — has also pressured companies into managing their risks more effectively and transparently.
Currency fluctuations are among the most important of these risks, especially in today’s globalised world where more and more companies operate internationally, importing and exporting goods and services.
The average monthly US dollar nominal of forex-option contracts traded in South Africa has increased from $2,2-billion in the five months to November 2004 to $4,7-billion in the five months to November 2006, an increase of about 113%.
We fully expect that level of growth to continue in the years ahead, especially given the fact that economists are still divided on just where the rand is heading. That means uncertainty, and companies don’t like uncertainty.
Ramlakan is head of forex structuring at Rand Merchant Bank
Of wedding cakes and other exotic options
VANILLA PUT: Buying a put option secures the right to sell a fixed amount of one currency for another currency at a set price, called a “strike price”, on a specific future date. For example, a buyer might buy a put option to sell US dollars for South African rands at R7,20 per $1 in three months’ time.
For this privilege, buyers pay a premium at the time they purchase the option, which might be, for example, 19c per $1.
Unlike a spot or forward transaction, a person who buys a put option is not obligated to sell the currency. When the specified future date arrives, if the market exchange rate between the two currencies is below the strike price, the holder of the put will sell the currency at the strike price. This is called exercising the put.
If the market exchange rate is above the strike price at the specified date, the holder of the put option will not exercise it and the option expires. The holder of the put option will prefer to sell the dollars at the higher market exchange rate.
EXOTIC OPTIONS: Exotic options like seagulls, sharkfins and wedding cakes are created by combining two or more vanilla options into complex structures or by providing options on options.