Foreign Exchange Derivative Products in India
[Extracted from article titled "Foreign Exchange Derivatives Market in India
Status and Prospects by Neeraj Gambhir & Manoj Goel ICICI Bank Ltd]

The forex derivative products that are available in Indian financial markets can be sectored into three broad segments viz.

• forwards,

• options,

• currency swaps.

We take a look at all of these segments in detail:

Rupee Forwards An important segment of the forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporates, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted. Although due to the Asian crisis, freedom to rebook cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers.

The exposures for which the rupee forward contracts are allowed under the existing RBI notification for various participants are as follows:

• Genuine underlying exposures out of trade/business

• Exposures due to foreign currency loans and bonds approved by RBI

• Receipts from GDR issued

• Balances in EEFC accounts (Exchange Earners Foreign Currency Accounts)

• They should have exposures in India.

• Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in market value/ inflows

• Dividends from holdings in a Indian company

• Deposits in FCNR and NRE accounts

The forward contracts are also allowed to be booked for foreign currencies (other than Dollar) and Rupee subject to similar conditions as mentioned above. The banks are also allowed to enter into forward contracts to manage their assets - liability portfolio. The cancellation and rebooking of the forward contracts is permitted only for genuine exposures out of trade/business upto 1 year for both exporters and importers, whereas in case of exposures of more than 1 year, only the exporters are permitted to cancel and rebook the contracts. Also another restriction on booking the forward contracts is that the maturity of the hedge should not exceed the maturity of the underlying transaction.

Cross currency forwards are also used to hedge the foreign currency exposures, especially by some of the big Indian corporates. The regulations for the cross currency forwards are quite similar to those of Rupee forwards, though with minor differences. For example, a corporate having underlying exposure in Yen, may book forward contract between Dollar and Sterling. Here even though its exposure is in Yen, it is also exposed to the movements in Dollar vis a vis other currencies. The regulations for rebooking and cancellation of these contracts are also relatively relaxed. The activity in this segment is likely to increase with increasing convertibility of the capital account.

The Reserve Bank of India has permitted authorised dealers to offer cross currency options to the corporate clients and other interbank counter parties to hedge their foreign currency exposures. Before the introduction of these options the corporates were permitted to hedge their foreign currency exposures only through forwards and swaps route. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. Currency options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium.

These contracts were allowed with the following conditions:

• These currency options can be used as a hedge for foreign currency loans provided that the option does not involve rupee and the face value does not exceed the outstanding amount of the loan, and the maturity of the contract does not exceed the un-expired maturity of the underlying loan.

• Such contracts are allowed to be freely rebooked and cancelled. Any premia payable on account of such transactions does not require RBI approval

• Cost reduction strategies like range forwards can be used as long as there is no net inflow of premia to the customer.

• Banks can also purchase call or put options to hedge their cross currency proprietary trading positions. But banks are also required to fulfill the condition that no 'stand alone' transactions are initiated.

• If a hedge becomes naked in part or full owing to shrinking of the portfolio, it may be allowed to continue till the original maturity and should be marked to market at regular intervals.

There is still restricted activity in this market but we may witness increasing activity in cross currency options as the corporates start understanding this product better.

Corporates in India can use instruments such as forwards, swaps and options for hedging cross-currency exposures. However, for hedging the USD-INR risk, corporates are restricted to the use of forwards and USD-INR swaps.

Another spin-off of the liberalization and financial reform was the development of a fledgling market in FC- RE swaps. A fledgling market in FC- RE swaps started with foreign banks and some financial institutions offering these products to corporates. Initially, the market was very small and two way quotes were quite wide, but the market started developing as more market players as well as business houses started understanding these products and using them to manage their exposures. Corporates started using FC-RE swaps mainly for the following purposes:

• Hedging their currency exposures (ECBs, forex trade, etc.)

• To reduce borrowing costs using the comparative advantage of borrowing in local markets (Alternative to ECBs - Borrow in INR and take the swap route to take exposure to the FC currency).

The market witnessed expanding volumes in the initial years with volumes upto USD 800 million being experienced at the peak. Corporates were actively exploring the swap market in its various variants (such as principal only and coupon only swaps), and using the route not only to create but also to extinguish forex exposures. However, the regulator was worried about the impact of these transactions on the local forex markets, since the spot and forward markets were being used to hedge these swap transactions.

So the RBI tried to regulate the spot impact by passing the below regulations:

• The authorized dealers offering swaps to corporates should try and match demand between the corporates

• The open position on the swap book and the access to the interbank spot market because of swap transaction was restricted to USD 10 million

• The contract if cancelled is not allowed to be rebooked or reentered for the same underlying.

The above regulations led to a constriction in the market because of the one-sided nature of the market. However, with a liberalizing regime and a buildup in foreign exchange reserves, the spot access was initially increased to USD 25 million and then to USD 50 million. The authorized dealers were also allowed the use of currency swaps to hedge their asset-liability portfolio. The above developments are expected to result in increased market activity with corporates being able to use the swap route in a more flexible manner to hedge their exposures. A necessary pre-condition to increased liquidity would be the further development and increase in participants in the rupee swap market (linked to MIFOR) thereby creating an efficient hedge market to hedge rupee interest rate risk.

There is some activity in other cross currency derivatives products also, which are allowed to be used to hedge the foreign currency liabilities provided these were acquired in accordance with the RBI regulations. The products that may be used are:

• Currency swap

• Coupon Swap

• Interest rate swap

• Interest rate cap or collar (purchases)

• Forward Rate Agreement (FRA) contract

However the regulations require that:

• The contract should not involve rupee

• The notional principal amount of the hedge does not exceed the outstanding amount of the foreign currency loan, and

• The maturity of the hedge does not exceed the unexpired maturity of the underlying loan.

Regulations of RBI governing these derivative Products given in the next article.