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Do you wish to improve the competitive position of your firm? Price with a forward rate if you face favorable forward points. Welcome to CurrencyCast, my name is Augustin MacKinlay. I’m the financial writer at Kantox and your host. Now, this is an important point, yet a fairly technical one,
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so let's illustrate it with the help of an example. Suppose that I'm a South African tour operator selling packages into the UK market. So there are two currencies involved, GBP, the British pound, and ZAR, the South African Rand, my functional currency.
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Now I want to protect the company against the transaction risk that arises from the time lapse between the moment the transaction is closed and the settlement, in British pounds. So there are going to be two transactions involved here,
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the commercial transaction itself, say that I sell today a package to be settled in British pounds in three months time, and a foreign exchange transaction by which I'm going to sell British pound forward for a value date that is going to coincide with a settlement of the commercial transaction.
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Now, how is the price going to be set? The most common procedure is to use the spot rate. So I would construct a price in ZAR in South African Rand based on my unit costs in that currency,
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and I would translate that price into GBP with the spot rates. That is the most common procedure. At the expiration of the two transactions, there's going to be a foreign exchange gain or loss on the commercial transaction that is going to be offset by a corresponding foreign exchange gain or loss on the forward market transaction.
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But something else will happen, because GBP has lower interest rates than ZAR, the South African Rand, so GBP or the British pound in the forward market will be quoted stronger than the spot market rates. And that's not an opinion,
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this is a mathematical certainty. And that's good news for the South African tour operator because on top of the commercial margin, I am set to make a net foreign exchange gain. Now, there is another possibility. Instead of pricing with a spot rate, I could use the forward rate.
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I would be translating the same price in ZAR with a stronger GDP rate. So that would mean that I would be in a position to lower my GBP prices, lower the prices to my British customers.
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I would be improving the competitive position of the firm and I would be in a position also to perhaps make a more efficient use of my invested capital. So the question is, why do many companies fail to take advantage of the possibility of improving their competitive position in the face of favourable forward ones?
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There appears to be two main explanations. On the one hand, there is perhaps a lack of understanding of the relationship between pricing with a FX rate and currency hedging. On the other hand, most Treasury management systems lack what we at Kantox call a strong FX rate feeder that would provide your commercial teams with the forward rates they need
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for pricing purposes. So while Treasury management systems cannot do that, Currency Management Automation solutions will allow you to provide the commercial teams with all the FX rates needed for pricing purposes, including the forward rates, and that would allow you to improve your firm's competitive position in a scenario of favorable forward points.
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