Value for Money: Third Currency Booking for GCC Customers
In 2003, the Gulf Co-operation Council (GCC) countries – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – pegged their exchange rate to the US dollar, in anticipation of a common currency by 2010. All six GCC countries’ current exchange rates are fixed.
The greatest disadvantage in a fixed-rate regime is that mercantile clients are not in a position to benefit from favourable exchange rate movements. This article explores the possibility of an alternate hedging tool that will enable the clients to take advantage of favourable exchange rate changes.
The option of covering a single contract into two or more contracts is known as third currency booking. For example, suppose an exporter has a €1m receivable in three months’ time. Within this scenario, they can hedge their position by booking a single contract for euro/Bahraini dinar (BHD) (domestic currency) or book two forward contracts for US dollar/BHD (domestic currency) and euro/US dollar. By netting the two contracts, we get euro/BHD (domestic currency). For any third currency booking, normally the intervening currency will be US dollars for both legs of the transaction, although other currencies can also be used as an intervening currency.
Why would an exporter resort to this method? As the US dollar/BHD is a pegged currency, the exporter does not benefit from additional rate movements; but if the dollar depreciates against the euro in three months’ time, the exporter can resort to booking through a third currency to take advantage of the exchange rate change.
The calculation would be as follows:
As of the deal date, the euro/BHD three months forward is 0.5566 and the rate computed by interpolating the exchange rates euro/US dollar 1.4765 and US dollar/BHD is 0.3770. The customer can either book the euro/BHD in one go, or split and cover the risk in two contracts. If the customer thinks that the US dollar will depreciate from its current forward rate of 1.4765 and move to 1.5000 levels in three months time, then they should keep the euro/US dollar position open and cover it later when the rate is 1.5000
The rate comparison is as follows:
The advantage of this product is that the exporter makes extra money without paying a premium up front. If the rates are unfavourable, then they need to take suitable remedial measures immediately to rectify the position.
Forward contracts can be booked for a fixed date delivery or as an option time delivery contracts. A forward contract booking should always be used for genuine exposures, but it can also be used for unanticipated exposures up to a limit set by the central banks of the respective countries.
For example, the third largest Asian economy’s central bank allows the booking/cancelling/rebooking and roll over of contracts in the ongoing markets without any restrictions to mercantile clients. This facility helps clients improve their earnings potential or cost reduction, as well as facilitating an enterprise risk management strategy.
In the case of a third currency booking, the exporter will sell foreign currency – i.e. euro against US dollar – and they will sell US dollar and buy BHD. Since they are selling in both transactions, the exporter should sell at higher rates to get the maximum advantage.
Is it necessary that both the legs of the transaction be covered simultaneously? No. The corporate customer can cover one leg of the transaction now and cover the remaining part later. Or they can initially cover a partial amount and then the remaining amount. They also don’t need to cover completely until the due date of the contract. For example, they can cover an upcoming month and then cover the maturity date later. The important point is that they cannot cover beyond the due date of the contract. Banks have to be careful in booking the contract because the customer cannot have a double exposure at any time.
Because a third currency booking is an excellent product that will help GCC mercantile clients benefit, it would be useful if all GCC central banks developed policies and educated their business communities regarding the various modalities which have to be complied with for the booking and cancelling of contracts. Then it will be possible to offer the facility to other types of business, for example non-exporters, non-importers, foreign institutional investors (FIIs), etc.
The corporate dealer and relationship manager need to do a feasibility study to see whether a customer has a genuine exposure and whether they know the inherent risk associated with the deal. Once this is ascertained, they need to obtain a disclosure statement and prepare the term sheet that will explain the various interest rate scenarios under which the expected movements are likely to take place. Then they need to calculate the value-at-risk (VaR) level. Back testing and stress testing can be done to check if the models used in VaR are appropriate to cover the position size, and also if the customer capital is sufficient to absorb the extreme losses that may arise due to unexpected events.
If the rates are moving in the right direction, the stop-losses (S/L) and take-profit (T/P) orders should be suitably modified to benefit and protect the favourable rate movements.
The trading and simulation software vendors should set up third currency booking modules to enable the participants to get hands-on experience with the product. Customers need to be able to access banks’ risk management module, so that they in turn can know their position at any point in time. Traders’ front-end deal capturing and order systems should pop up with alert messages for dealers to square the position if they are nearing the S/L or T/P levels. Software vendors should also ensure clients do not initiate a double exposure – suitable checks and radio button fields should be deactivated while inputting the deal. This will help avoid inputting a wrong deal.
In addition, the Bahrain Institute of Banking and Finance (BIBF) and other academic training institutes should play a diligent role in educating bankers and corporates when they come for training. The ACI, the financial markets association, and its members should devise topics on third currency booking, and have the theory and calculations problems built into their exam syllabus.
Although the GCC common currency is a long way from becoming a reality, in the meantime mercantile clients can benefit from a third currency hedging product. All the stakeholders need to work hard to ensure that third currency booking takes off smoothly, so that valued clients can be quoted a competitive price.