Mitigating USDZAR Fluctuations for a North American Client
September 17, 2024
We have been working closely with a North American client who is exposed to USDZAR currency fluctuations, due to its operations in South Africa. Specifically, a short USD and long ZAR exposure. The client’s appetite for more sophisticated hedging practices has grown rapidly with the use of the platform, starting with spot payments, moving then to Forwards and now Forward Extras. This success story will focus on the advised transition from forward to Forward Extras.
The client was originally using Forward contracts to hedge the purchase of ZAR, structuring each contract as a monthly strip for up to 1 year. Although successfully generating a forward carry, the Forwards capped upside participation and proved to be a liquidity-intensive product as several positions expired deep OTM. More often than not, the client would miss out on favorable market movements leading the client to rethink the age-old line - To Hedge or Not to Hedge.
To solve this issue, Deaglo suggested the client consider using Forward Extras - a less risk-averse alternative. The Forward Extra is a derivative that combines the features of a forward contract with the flexibility of an option. It is designed to provide the hedger with complete downside protection while capping the upside potential when the underlying price hits the barrier. In this specific USDZAR case, these are structured with a long put and a short call with an ‘Up & In’ barrier.
Although locking in a less favorable rate than the Forward at inception, the strategy proved effective given the low probability of the barrier kicking and registering a negative MTM allowing the client to access upside participation.
Strategy Simulation Construction:
Using the Strategy Simulation tool, we assessed the most cost-effective Forward Extra. For comparative reasons, a Forward was used with a rate = 18.4740, and carry = 3.39%.
Strategy Simulation Output:
The Strategy Simulation tool enabled us to recommend Forward Extra-3 to the client as it outperformed the other strategies. Forward Extra-3 has approximately the same expected value as the Forward, yet has a much higher upside potential (11.6390% vs. 3.3914%).
Margin Simulation Output:
Using the Margin Simulation tool, we also assessed simulated potential margin calls, which the client requested to avoid due to limited liquidity in its cash flow. We recommended again using Forward Extra-3 given the large reduction in mean expected MtM (0.16966%) versus the Forward contract (2.1320%).
