Background
A New Zealand-based exporter operates in the timber log trading industry, serving markets in China and Singapore. Operating on a narrow margin of 5% due to the volatile nature of the commodity market, the monthly export volume amounts to USD 8,000,000.00, with a total FX volume for the year totaling USD 96 million.
Strategy: Forward contract
To hedge against the risk of the NZD strengthening against the USD, potentially reducing profit margins, a strip of Forward contracts with Corporate Alliance FX is entered into. Each Forward contract covers USD 2.5 million for the next 6 months. This action locks in the current exchange rate of 0.6300 (1.5873) USD into NZD for each monthly settlement date, protecting gross margins from adverse currency movements.
Analysis and Benefits
- Revenue Forecasting: The Forward contracts allow accurate revenue forecasting on a monthly basis, regardless of exchange rate fluctuations, facilitating effective budgeting and financial planning.
- Risk Mitigation: Locking in the exchange rate proactively mitigates the risk of NZD strengthening against the USD, ensuring profitability and operational stability despite currency market volatility.
- Assured Conversion: With Forward contracts in place, there’s assurance of converting export proceeds into NZD at agreed-upon rates monthly, regardless of currency market behavior, eliminating uncertainty and fostering confidence in business operations.
Outcomes
As anticipated, the NZD gradually weakens against the USD leading up to the settlement date.
Without Forward Contract:
When the NZD depreciates to 0.6100, the exporter faces challenges when converting proceeds from timber exports into NZD.
- Initial Proceeds: USD 8,000,000.00
- Conversion Rate at Settlement: 0.6100 NZD/USD
- Actual NZD Amount Received: USD 8,000,000.00 * 0.6100 = NZD 4,880,000.00
With Forward Contract:
The exporter secures a favorable exchange rate, mitigating the impact of the depreciated NZD against the USD.
- Forward Contract Exchange Rate: 0.6300 NZD/USD
- Actual NZD Amount Received: USD 8,000,000.00 * 0.6300 = NZD 5,040,000.00
Utilizing the Forward contract ensures the exporter receives NZD 160,000.00 more compared to not having the contract in place. This strategic decision safeguards profitability and demonstrates effective risk management in volatile currency markets.
