YIELD X CURRENCY FUTURES BROCHURE JUNE 2009

1 YIELD X CURRENCY FUTURES BROCHURE JUNE 2009

2 Currency Futures for corporate clients The Currency Futures market on the JSE was implemented in order to further develop South Africa s financial markets and to increase its liquidity. The Minister of Finance, Trevor Manuel, approved the Currency Futures for the important reasons above. Currency Futures budget speech dispensations granted for corporate clients The budget speech of 2008 specified that all South African corporate entities qualify for trading in currency futures with no restrictions on the value traded. Corporate bodies include: private and public companies, limited and unlimited companies, close corporations, partnerships, hedge funds, trusts and banks. The corporate bodies are not required to seek approval from the South African Revenue Service to trade in currency futures nor are they required to report their trades. What are Currency Futures? Currency Futures are derivative contracts that are traded on JSE s derivative platform called Yield-X. A Currency Futures contract is an agreement between two parties: Party A agrees to buy (long) the underlying exchange rate and Party B agrees to sell (short) the underlying exchange rate at some specified date in the future. Therefore Party A will profit from an increase in the underlying exchange rate (an increase in the value of the foreign currency) and Party B will profit from a decrease in the underlying exchange rate (a decrease in the value of the foreign currency). Why trade Currency Futures? Currency future contracts allow investors to hedge against foreign exchange risk or currency risk. Since these contracts are marked-tomarket daily, investors can by closing out their position exit from their obligation to buy or sell the currency prior to the contract s delivery date. These contracts also allow investors to speculate on the future movements of the exchange rates. For example, companies whose business processes entail receiving/settling transactions in a foreign currency can use this instrument to lock in a specific rate. Currency Futures have now provided investors a tool that allows them to hedge transactions that were previously not hedged using the conventional methods (over-the-counter instruments- forward exchange contracts). Currency Futures contracts are also useful tools for diversifying ones South African based portfolio internationally. This allows the portfolio to be exposed to the performances of international economies. These instruments can also be used as a hedging tool during times of below average credit facilities. Banks do not experience high credit risk (default risk) from these tools as the Currency Futures are traded on the exchange. How are Currency Futures quoted? $/ZAR 10.47 This is read as the number of rands needed to purchase one dollar or alternatively, the value of one dollar (the foreign currency) in terms of the rand (the local currency). Currency Futures contracts offered PSG Prime trades the following Currency Futures contracts: USD/ZAR EUR/ZAR GBP/ZAR AUD/ZAR Exchange rate, ratio of exchange between two Currencies 1USD = ZAR10.47 1EURO = ZAR13.23 1POUND = ZAR15.58 BASE CURRENCY QUOTED CURRENCY Factors that influence exchange rates The exchange rate between two countries currencies is determined by the economic supply and demand forces. These forces are in turn influenced by the following factors: 1) Inflation If South Africa s price levels are lower than the rest of the worlds then South African exports become more competitive as they are cheaper. The demand for exports increases thus causing an increase in demand for the South African Rand. Therefore the rand appreciates and the exchange rate of a foreign currency in terms of the rand will decrease. 2) Interest Rate If the South African Interest rate rises relative to the rest of the world, the South African investments become more attractive to invest in. The demand for the rand rises causing the rand to appreciate. This movement can be explained by the interest rate parity that states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Over the long run the spot rate adjusts to reflect the differential in interest rates between the two countries. 3) Balance of Payments The Balance of payments consists of the Current Account and the Capital Account. If the Current Account has a deficit balance (value of imports are greater than the value of exports) and this can be supported by a surplus balance on the Capital Account then the exchange rate is unaffected. If however there is insufficient capital flow into the country then the exchange rate will depreciate. 4) Speculators The exchange rate is not only affected by the economic factors mentioned above but is also affected by the sentiments of the financial market. If speculators believe that the rand will rise in the future then they will begin to buy rands today in order to lock in a profit in the future. This increases the demand for rands in turn causes the value of the rand to rise. Pricing Currency Futures contracts The pricing of Currency Futures is dependent on the spot exchange rate and the interest rates of the two countries as shown below: forward rate = spot rate 1+ 1+ interest rate quoted currency x day count quoted currency annual bases interest rate base currency x day count base currency annual bases Forward rate = the futures contract price in terms of the local currency Spot rate = current exchange rate between two countries in terms of the local currency Day count = time to maturity. Quoted interest rate = the domestic interest rate Base interest rate = foreign currency interest rate

3 to pay the Initial Margin by noon the following day that the position was opened. The Initial Margin is on average 4% of the nominal value of the contract opened. This margin amount earns a market related interest that can either be routed to the client on a monthly basis or collectively when the position is closed. The Variation Margin is the daily settlement of the profit and losses of the investor s position. The position is Mark-to Marketed (MTM) daily and the profit or loss per day is recorded. The MTM process entails calculating the price movement from the close of yesterday to the close of today. The difference in the closing prices determines the profit or loss of the position. If the difference is positive then the profit is paid to the investor. If the difference is negative then the investor has to pay the JSE clearing house the amount owed. The payments above are referred to as Variation Margin. Performance Guarantee Since the Forwards contract is customized and traded over-the-counter, it is difficult to exit a position. There is also no monetary guarantee that contractual obligations will be met. The profits and losses are cumulatively settled at expiry in cash. The credit risk on these contracts is high since the counterparty is liable to uphold their obligations. The Futures contract has a margin requirement which guarantees the fulfilment of contractual obligations. The value of the position is markedtomarket rates with daily settlements of profits and losses. Futures and Forwards Comparison Contract size Quoted in term of the foreign currency, in denominations of a 1000 Expiry months and date March June September December The contracts expire two business days before the third Wednesday of each expiry month. In the months where the day is not a business day, the contract will expire the first business day before the allocated day. Settlement When the contracts expire, no physical delivery of the foreign currency takes place. Instead, the contracts are settled in terms of rands. Margins Since the Currency Futures are exchange traded, they hold low credit risk. The JSE follows a method known as margining which serves as a safety net in the case of defaulting counterparties. Margining requires that both parties (buyer and seller) put up an Initial Margin and maintains a daily Variation Margin when necessary. The Initial Margin is required when a contract is purchased (longed) or sold (shorted); when a Currency Future position is opened. The client will deposit cash into the bank that will then deposit it with the JSE clearing house. The client has Closing out or rolling over a Position A Currency Futures contract position can be closed out, left to expire or rolled over. Closing out a contract entails the investor taking an equal and opposite position to his existing position. For example, if an investor has entered a long position in the Currency Futures contract he would need to sell that contract which is equivalent to entering into the same contract but taking a short position. The net of the two positions will be zero thus closing out the initial contract position. The contract can also be rolled over. This means that the investor can choose to keep the same position passed the expiry date of the contract, that is, he can roll the position over to the next expiry date. The exchange does not charge a fee for rolling over a position. The investor benefits from rolling his position over because the same hedge is preserved. Alternatively, the investor can let the contract automatically expire on the date of expiry. Here, the exchange closes out the position and charges a fee for doing so. On the expiry day the contract position is Mark-to-Marketed for the last time and the last Variation Margin call is made. Futures versus Forward Contracts What is it? A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. Method of per-termination A Forward contract is to be entered into with same or different counterparty. The counter-party risk remains while terminating with different counterparty. For a Futures contract, the investor will need to enter into an equal and opposite position on the exchange. FUTURES FORWARD TRADE Via regulated Over the counter (OTC) exchange CONTRACTS Standardised Tailor Made SETTLEMENT LIQUIDITY COUNTER- PARTY RISK LIMITATIONS ON COMPA- NIES Currency risk Rand cash settled & Daily Mark-to Market Market makers allow for easy entry/exit No No SARB approval required Currency risk consists of the following: Physically settled (foreign currency delivered on expiry date) Can be traded out with cash flow implications Yes SARB regulated Transaction exposure Transactions that involve receipts and payments in foreign currency are exposed to this risk. Translation exposure Businesses that experience profits and losses in foreign currency are vulnerable to the exchange rate and thus a translation exposure. Economic exposure Market values of businesses such as those mentioned above are also dependant to the exchange rate. The risk is that the market value will decrease due to the weakening of the local currency.

4 Hedging Investors enter into a long (short) Currency Futures position if they speculate that the local currency will depreciate (appreciate). The hedging mechanism comes into play when the losses incurred from purchasing (selling) the foreign currency on the market at the unfavourable spot rates are offset by the gains made on the Currency Futures contracts. As shown in the graphs, Currency Futures contracts have a linear payoff. This means that taking an opposite position to what the unfavourable cash position is will hedge the exchange rate risk completely. Profit/Loss in Rands Profit/Loss in Rands 6000 4000 2000-2000 -4000-6000 6000 4000 2000-2000 -4000-6000 Long Currency Futures Payoff Profile 0 6.6 7 7.4 7.8 8.2 8.6 9 9.4 9.8 Currency Futures Price in Rand Short Currency Futures Payoff Profile 0 6.6 7 7.4 7.8 8.2 8.6 9 9.4 9.8 Currency Futures Price in Rand Risk of trading Currency Futures The main risk factors of trading in Currency Futures are: 1) Gearing or Leveraging This is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. In terms of Currency Futures the investor deposits an initial margin in order to hold a larger nominal value position on the market. This means that they are exposed to the risk of the full nominal value of the position. Gearing can pose as a large risk to speculating investors who are not holding the underlying instrument or cash equivalent. Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would ve been if the investment had not been leveraged - leverage magnifies both gains and losses. 2) Variation margin The principle risk for hedging clients is the daily variation margin calls that come with holding a Currency Futures position. These daily calls are dependent on the market movements of the exchange rate and can be considerably larger than the initial margin posted. Should the client be unable to put up the variation margin call, the bank is obligated to close the position. Currency Futures Contract Summary specifications Contract name Underlying Instrument Contract months Listing programme Expiry months Expiry date Expiry time Expiration valuation Contract size Price quotation Minimum price move Settlement Initial margin requirements Mark-to-Market Exchange fees Futures: Market times j-rand: Derivatives on foreign currencies Rate of exchange between one unit of foreign currency and SA rand March, June, September and December Near, middle and far contracts March, June, September and December. Two business days prior to the 3rd Wednesday of the expiry month (or the previous business day if that day is a public holiday) 10am New York or, 4pm in SA winter months 5pm in SA summer months Arithmetic average of the underlying spot taken every 60 seconds (100 iterations) between 3.31pm and 4pm (SA winter months) 4.31pm and 5pm (SA summer months) 1 000 foreign currency nominal (for example USD1 000) Rand per one unit of foreign currency to four decimals ZAR0.10 Cash settled in ZAR As determined by JSE Portfolio Scanning Methodology The calculated forward value of the arithmetic average of the traded underlying spot taken for a five minute period between 4.55pm and 5pm ZAR1.14 (incl VAT) per contract As determined by Yield-X (9am - 5pm) Example: Hedging a transaction when the rand is weakening John wishes to travel to the America in three months time. He decides to hedge himself in case the rand further weakens before he manages to buy his dollars for the trip. He does this by purchasing Currency Futures contracts. If John has decided to take $10 000 on holiday he will need to purchase 10 contracts at $1 000 each and lock in an exchange rate of R9.72. John now holds a spot exposure equal to the value of $10 000 or R97 200. Since Currency Futures contracts require the investors to deposit only a portion of this total spot exposure, he will not need to put up the full amount. If say the initial margin is R480 per contract, he will only be required to deposit R4 800. Over and above the initial margin, he will also be liable to pay a brokerage fee to the member of his choice. In December John is now prepared to exchange his rands for dollars in preparation of his holiday. He has found that his suspicions were correct about the rand weakening with the spot exchange rate now at R10.47. Luckily John has fixed in a rate of R9.72 and therefore sells his contracts and saves R7 500 (R10.47-R9.72*10*1000). John s long Currency Futures position cash flows This table shows the daily cash flows of John s long futures position over the first three days and last 2 days: Currency future trade price Initial margin MTM price Profit/ Loss per day Net cash flow for the day DAY 1 DAY 2 DAY 3 DAY 29 DAY 30 Zar9.72 Zar0 Zar0 Zar0 Zar10.47 (Zar4 800) Zar0 Zar0 Zar0 Zar4 800 Zar9.8478 Zar9.8512 Zar9.8834 Zar10.29 Zar10.47 Zar1278 (9.8478-9.72* (Zar3522) (-4 800+ 1278) Zar34 (9.8512-9.8478* Zar322 (9.8834-9.8512* N/A Zar1800 (10.47-10.29* Zar34 Zar322 N/A Zar1800 Day 1: John deposits the initial margin of R4 800. The mark-to-market for the day is R1 278 causing a net variation margin of negative R3 522.

5 Day 2: The rand weakens and there is a positive variation margin of R34. Day3: The rand further weakens and John receives a positive margin. Day 30: John decides to sell his Currency Futures contract and realise a cumulative profit of R7 500. A spot transaction would have cost John R104 700 but because he fixed the exchange rate to hedge himself against exchange rate market fluctuations, he has only paid R97 200 for the same amount of dollars. PSG Prime (Pty) Limited 2nd Floor, PSG House, Alphen Park, Constantia Main Road, Constantia, 7806 Private Bag X3, Constantia, 7848, South Africa Telephone: +27 21 799 8000 Fax: +27 21 799 8185 Direct line: Ockert van Niekerk: 021 799 8111, Ciaan Badenhorst: 021 799 8138 Disclaimer This document has been prepared solely for information purposes by PSG Prime (PTY) LTD ( PSG ). Any indicative terms provided to you are provided for your information and do not constitute an offer, a solicitation of an offer, invitation to acquire any security or to enter into any agreement, or any advice or recommendation to conclude any transaction (whether on the indicative terms or otherwise). Any information, indicative price quotations, disclosure materials or analyses provided to you have been prepared on assumptions and parameters that reflect good faith determinations by us or that have been expressly specified by you and do not constitute advice by us and it should not be relied upon as such. The information, assumptions and parameters used are not the only ones that might reasonably have been selected and therefore no guarantee is given as to the accuracy, completeness, or reasonableness of any such information, quotations, disclosure or analyses. No representation or warranty is made that any indicative performance or return indicated will be achieved in the future. This document is not an official confirmation of terms, and any transaction that may be concluded pursuant to this document shall be in terms of and confirmed by the signing of appropriate documentation, on terms to be agreed between the parties. The information in the document is also subject to change without notice. PSG, or an associated company, may have effected or may effect transactions for its own account in any investment outlined in the document or any investment related to such an investment. Prospective investors should obtain independent advice in respect of any product detailed in this document, as PSG provides no investment, tax or legal advice and makes no representation or warranty about the suitability of a product for a particular client or circumstance. Transactions described in this material may give rise to substantial risk and are not suitable for all investors. PSG will only provide investment advice if specifically agreed to by PSG in appropriate documentation, signed by PSG. This information is to be used at your own risks, and PSG makes no representation with regards to the correctness of the information herein. PSG Prime (PTY) LTD is an authorized Financial Services Provider (License No.:5903)