Hello, and welcome to my first installment of "Derivatives Demystified."
When you hear the phrase "derivatives trading," it most likely awakens an emotional response. It could be one of fear of a dangerous, complex bomb waiting to blow up. But, on the other hand, if you get it right, it could be one of exciting prospects of Ndebele-painted yachts, helicopters, and matching Hublots. In reality, although it could be one of those blockbuster scenarios in extreme circumstances, derivatives are efficient money-management tools used daily. Regular readers should find themselves proficient in talking derivatives at the next braai.
So what is a derivative? It's a paper contract with a price that references an underlying asset's price. That's it. Generally, the higher the asset's price, the higher the derivative's price. The more volatile the asset's price, the higher the derivative's price. The longer the term of the derivative, the higher the derivative's price.
I have gained my derivatives knowledge not from books but from trading the markets, and I hope to make literature practical.
Today's example is what we derivative traders call DCDs (Dual Currency Deposits, NOT Derivatives Consternation Disorder). DCDs are not hedges against currency movements but are yield-enhancing products.
The DCD is the derivative and references exchange and interest rates as underlying assets.
Who trades DCDs?
- A customer who holds a cash balance (in any currency)
- Who aims to enhance the interest they receive on that cash
- Who has a tolerance for converting that cash into a different currency
How does it work? The customer places cash on a fixed-term deposit with Investec. We agree on a 'Conversion Rate' and an 'Enhanced Interest Rate.' If the spot rate on maturity time has traded through the Conversion Rate, Investec will convert the deposited currency at the Conversion Rate. Investec will also pay the Enhanced Interest back in the deposited currency.
Say I'm importing a shipment, and I have an invoice for USD100,000. I am unsure of the exact date the freight will arrive, but I know payment will be due on arrival. I expect the shipping will take more than one month.
I like to imagine that this shipment of mine is for Space Grey iPad Pros and matching Apple Pencils (why are they not called iPens?). I'm tired of sharpening a Staedtler to write in my Moleskine. I think the future is now, and I'm "going digital."
Currently, USDZAR is trading at 16.00, which means in ZAR, this shipment will cost me ZAR1,600,000.
Let's say I have ZAR1,600,000 on deposit in my account and am currently earning 4.95%.
Alternatively, I decide to enter a 1-month DCD. Investec and I agree on a conversion rate of 15.50, and the enhanced interest I'll be earning on my deposit is 7.19% (2.24% above the base rate).
Possible outcome 1: At the maturity time of the contract, USDZAR is trading above 15.50. Investec pays back my ZAR1,600,000 and interest of ZAR9,586-67*. I now have a total of ZAR1,609,586-67 to buy USD with. The risk is that USDZAR trades above 16.0959** at the end of 1-month, and I'll need more ZAR to buy my USD100,000. This risk exists on a standard deposit too.
Possible outcome 2: At the maturity time of the contract, USDZAR is trading at 15.40 (below our agreed conversion rate). Investec pays back USD103,225-81*** and interest of USD618-49****. I now have a total of USD103,844-30, of which I'll use USD100,000 for my shipment and USD3,844-30 profit.
*1,600,000 x (7.19%/12)
**1,609,586-67 / 100,000
***1,600,000 / 15.50
****9586-67 / 15.50
A different scenario may be for a client earning money in USD with ZAR obligations such as dividend payments.
I imagine this client earns USD income from an investment in properties in Nashville (aka Cashville). In addition, the client has announced a sweet-as-a-peach dividend to their South African investors.
Let's say the client will distribute dividends after one month worth ZAR10,000,000, and at the current exchange rate of 16.00, they need to convert USD625,000 to make that payment.
The client has USD625,000 on deposit in their account and is currently earning 1.25%. Not really country music to anyone's ears.
Alternatively, they decide to enter a 1-month DCD. Investec and the client agree on a conversion rate of 16.50, and the enhanced interest they'll earn on their deposit is 4% (2.75% above the base rate).
Possible outcome 1: At the maturity time of the contract, USDZAR is trading below 16.50. Investec pays back my USD625,000 and interest of USD2,083-33*. I now have a total of USD627,083-33 to buy ZAR with. The risk is that USDZAR trades below 15.9468** at the end of 1-month, and I'll need more USD to buy my ZAR10,000,000. This risk exists on a standard deposit too.
Possible outcome 2: At the maturity time of the contract, USDZAR is trading at 16.60 (above our agreed conversion rate). Investec pays back ZAR10,312,500*** and interest of ZAR34,374-95****. I now have a total of ZAR10,346,874-95, of which I'll use ZAR10,000,000 for my payments and ZAR346,874-95 profit.
*625,000 x (4%/12)
**10,000,000 / 627,083-33
***625,000 x 16.50
****2,083-33 x 16.50
Mr. Warren Buffet says, "derivatives are financial weapons of mass destruction" – but are they really? You know my answer!
Keep an eye out for my next installment where I’ll be demystifying “delta”!