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Guidelines for the Management of Crown and Departmental Foreign Exchange Exposure

5.  Covering Transaction Exposure

A.  Transaction Exposure Limit

Guideline 5

The policy document must state the Transaction Exposure Limit for each individual currency. The Transaction Exposure Limit for an individual currency must not exceed NZ $100,000.

Definition

  1. The Transaction Exposure Limit refers to the maximum level of uncovered exposure a department can have to an individual currency expressed as a New Zealand-dollar equivalent. A department’s level of net transaction exposure should be checked against this limit daily where transactions occur frequently and at least once a month where transactions are infrequent.

  2. A department’s net transaction exposure to a currency includes all current (e.g. bank accounts) and future cash inflows and outflows for that currency discounted to a present day equivalent and then aggregated. The New Zealand-dollar equivalent may be obtained by applying the spot exchange rate between the relevant currency and the New Zealand dollar. It is important that only identified cash inflows and outflows are included in the calculation of net transaction exposure (refer to section 4 of this document).

  3. Policy

  4. The Transaction Exposure Limit for an individual currency is NZ $100,000.

  5. If the total net transaction exposure for an individual currency is above the Transaction Exposure Limit, it is the responsibility of the department to cover this risk fully using approved instruments and counterparties.

Example

Date USD Cash Outflow USD Cash Inflow Net Exposure (USD) Present Value (USD)  
Bank Account   $1,200,000 $1,200,000 $1,200,000  
17-Sep-03 -$500,000   -$500,000 -$499,384  
14-Oct-03 -$3,000,000 $2,000,000 -$1,000,000 -$997,883  
17-Nov-03 -$250,000   -$250,000 -$249,203  
12-Feb-04   $300,000 $300,000 $298,132  
14-Apr-04 -$100,000   -$100,000 -$99,126  
15-Jun-04 -$200,000 $100,000 -$100,000 -$98,844  
        Net Transaction Exposure NZD Equivalent
        -$446,307 -$769,496

In this example the department has exceeded the Transaction Exposure Limit and therefore needs to buy USD. This could be done by undertaking a forward FX transaction to sell NZD and buy USD 500,000 on the 14th October 2003.

The table below shows the calculation after this transaction has been completed.

Date USD Cash Outflow USD Cash Inflow Net Exposure (USD) Present Value (USD)  
Bank Account   $1,200,000 $1,200,000 $1,200,000  
17-Sep-03 -$500,000   -$500,000 -$499,384  
14-Oct-03 -$3,000,000 $2,500,000 -$500,000 -$498,941  
17-Nov-03 -$250,000   -$250,000 -$249,203  
12-Feb-04   $300,000 $300,000 $298,132  
14-Apr-04 -$100,000   -$100,000 -$99,126  
15-Jun-04 -$200,000 $100,000 -$100,000 -$98,844  
        Net Transaction Exposure NZD Equivalent
        $52,634 $90,748

B.  Approved Instruments

Guideline 6

The policy document must identify the instruments which the department may use to cover its transaction exposure, together with any limitations on their use. Such limitations should include:

i.     maximum utilisation of a particular instrument without reference to the Chief Executive;

ii.     specific approval from the Chief Executive required to use a particular instrument; and

iii.   use of particular instruments to cover specified types of transactions.

Definition

  1. There are two types of instruments that may be used to cover foreign-exchange exposure:

    1. Spot Foreign-Exchange Contract – for not more than two-business-day settlement. This is used where a department needs to buy or sell currencies immediately (eg, to pay an invoice).

    2. Forward Foreign-Exchange Contract – for settlement at a future date. This is used when a department has identified a foreign-exchange transaction exposure but does not need to buy or sell the cash until a future date (eg, a contract is agreed to purchase goods in six months time in US dollars).

  2. An example of each instrument is contained in Schedule I.

  3. Note that both instruments will cover the foreign-exchange exposure but differ in the timing of the cash flows. Irrespective of the instrument, the department must ensure that the term of cover entered into matches the term of the related exposure.

Policy

  1. Departments may transact only in spot and forward-exchange contracts. Spot and forward-exchange contracts may be executed with the NZDMO or any counterparty that meets the minimum credit rating criteria outlined under Guideline 8.

Term Deposits

  1. Pursuant to sections 23 and 65 of the Public Finance Act 1989, departments can place foreign-currency funds on deposit with the NZDMO. This may be appropriate when a department wishes to delay the delivery date of their foreign-currency funds e.g. the department purchases USD 5 million for a given settlement date, but does not require the funds until a future date.

  2. The department does not earn interest on the funds that are deposited with the NZDMO. Instead the Crown earns interest from the onward investment of those funds by the NZDMO.

  3. The procedures for placing a deposit with the NZDMO are covered under Schedule II of this document.

C.  Historic-Rate Rollovers

Guideline 7

The policy document should state that the department is prohibited under the Public Finance Act 1989 from rolling forward an existing foreign-exchange contract at a historic rate.

Definition

  1. A historic-rate rollover refers to a situation where an existing foreign-exchange contract is rolled forward using the rate applicable when the original contract was entered into, rather than at the current market rate. The situation generally arises when a department needs to roll out the delivery date because the timing of its foreign-currency requirement has changed. Furthermore, a department may want to roll forward the historic rate because;
    • the exchange rate has moved favourably and, therefore, renegotiating at the historic rate means that the department might avoid having to realise a profit for return to the Crown, thereby retaining purchasing ability; or
    • the exchange rate has moved unfavourably and, therefore, renegotiating at the historic rate means that the department may be able to postpone realising a loss.

Policy

  1. Departments are prohibited under the Public Finance Act 1989 from rolling over a foreign-exchange contract at an historic rate as, under certain circumstances, it could be equivalent to borrowing from the counterparty.
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