"The gradual liberalization of Indian economy has resulted in substantial inflow of foreign capital into India. Simultaneously dismantling of trade barriers has also facilitated the integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures"¹

"In India, the economic liberalization in the early nineties provided the economic rationale for the introduction of FX derivatives. Business houses started actively approaching foreign markets not only with their products but also as a source of capital and direct investment opportunities. With limited convertibility on the trade account being introduced in 1993, the environment became even more conducive for the introduction of these hedge products. Hence, the development in the Indian forex derivatives market should be seen along with the steps taken to gradually reform the Indian financial markets. As these steps were largely instrumental in the integration of the Indian financial markets with the global markets. Developments in the capital inflows Since early nineties, we are on the path of a gradual progress towards capital account convertibility. The emphasis has been shifting away from debt creating to non-debt creating inflows, with focus on more stable long term inflows in the form of foreign direct investment and portfolio investment. In 1992 foreign institutional investors were allowed to invest in Indian equity & debt markets and the following year foreign brokerage firms were also allowed to operate in India. Non Resident Indians (NRIs) and Overseas Corporate Bodies (OCBs) were allowed to hold together about 24% of the paid up capital of Indian companies which was further raised to 40% in 1998. In 1992, Indian companies were also encouraged to issue ADRs/GDRs to raise foreign equity, subject to rules for repatriation and end use of funds. These rules were further relaxed in 1996 after being tightened in 1995 following a spurt in such issues. Presently, the raising of ADRs/GDRs/FCCBs is allowed through the automatic route without any restrictions.¹

In this context it is relevant to study the regulations of RBI governing forex derivatibves. These have evolved over the years and finally crystallised at the present in the Foreign Exchange Management (Foreign exchange derivative contracts ) Regulations, 2000. The regulations have further been amended in the year 2003 to reflect further the growing needs of the country.

‘Cash delivery ’
means delivery of foreign exchange on the day of transaction ;

‘Forward contract’
means a transaction involving delivery, other than Cash or Tom or Spot delivery, of foreign exchange;

‘Foreign exchange derivative contract'
means a financial transaction or an arrangement in whatever form and by whatever name called, whose value is derived from price movement in one or more underlying assets, and includes,

1. a transaction which involves at least one foreign currency other than currency of Nepal or Bhutan, or

2. a transaction which involves at least one interest rate applicable to a foreign currency not being a currency of Nepal or Bhutan , or

3. a forward contract, but does not include foreign exchange transaction for Cash or Tom or Spot deliveries;

‘Registered Foreign Institutional Investor (FII) ’
means a foreign institutional investor registered with Securities and Exchange board of India;

‘Spot delivery
means delivery of foreign exchange on the second working day after the day of transaction;

‘Tom delivery’
means delivery of foreign exchange on a working day next to the day of transaction;

A person resident in India may enter into a foreign exchange derivative contract in accordance with provisions as contained in Schedule I of the Regulations, to hedge an exposure to risk in respect of a transaction permissible under the Act, or rules or regulations or directions or orders made or issued thereunder.

The said provisions are as under

A person resident in India may enter into a forward contract with an authorised dealer in India to hedge an exposure to exchange risk in respect of a transaction for which sale and/or purchase of foreign exchange is permitted under the Act, or rules or regulations or directions or orders made or issued there under, subject to following terms and conditions -

1. the authorised dealer through verification of documentary evidence is satisfied about the genuineness of the underlying exposure,

2. the maturity of the hedge does not exceed the maturity of the underlying transaction,

3. the currency of hedge and tenor are left to the choice of the customer,

4. where the exact amount of the underlying transaction is not ascertainable, the contract is booked on the basis of a reasonable estimate,

5. foreign currency loans/bonds will be eligible for hedge only after final approval is accorded by the Reserve Bank where such approval is necessary,

6. in case of Global Depository Receipts (GDRs) the issue price has been finalised,

7. balances in the Exchange Earner’s Foreign Currency(EEFC) accounts sold forward by the account holders shall remain earmarked for delivery and such contracts shall not be cancelled. They may be ,however, be rolled-over,

8. contracts involving rupee as one of the currencies, once cancelled shall not be rebooked although they can be rolled over at ongoing rates on or before maturity. This restriction shall not apply to contracts covering export transactions which may be cancelled, rebooked or rolled over at on-going rates,

9. substitution of contracts for hedging trade transactions may be permitted by an authorised dealer on being satisfied with the circumstances under which such substitution has become necessary.

10. A person resident in India may subject to the terms and conditions prescribed by Reserve Bank of India. may enter into a forward contract with an authorised dealer in India to hedge an exposure to exchange risk in respect of transactions denominated in foreign currency but settled in Indian rupees".

(1) A person resident in India who has borrowed foreign exchange in accordance with the provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000 , may enter into an Interest rate swap or Currency swap or Coupon Swap or Foreign Currency Option or Interest rate cap or collar (purchases) or Forward Rate Agreement (FRA) contract with an authorised dealer in India or with a branch outside India of an authorised dealer for hedging his loan exposure and unwinding from such hedges,

Provided that –

1. the contract does not involve rupee,

2. the Reserve Bank has accorded final approval for borrowing in foreign currency,

3. the notional principal amount of the hedge does not exceed the outstanding amount of the foreign currency loan, and

4. the maturity of the hedge does not exceed the un-expired maturity of the underlying loan,

(2) A person resident in India, who owes a foreign exchange or rupee liability, may enter into a contract for foreign currency-rupee swap with an authorised dealer in India to hedge long term exposure,

(3) The contract entered into under sub-paragraph 2, if cancelled shall not be rebooked orre-entered, by whatever name called.

3. (1) A person resident in India may enter into a foreign currency option contract with an authorised dealer in India to hedge foreign exchange exposure of such person arising out of his trade : Provided that in respect of cost effective risk reduction strategies like range forwards, ratio-range forwards or any other variable by whatever name called there shall not be any net inflow of premium.

Explanation

The contingent foreign exchange exposure arising out of submission of a tender bid in foreign exchange is also eligible for hedging under this sub-paragraph.

(2) A Transactions undertaken under sub-paragraph (1) may be freely booked and/or cancelled.

A person resident outside India may enter into a foreign exchange derivative contract with a person resident in India in accordance with provisions contained in Schedule I of the Regulations, to hedge an exposure to risk in respect of a transaction permissible under the Act, or rules or regulations or directions or orders made or issued thereunder.

The said provisions are as under

A Registered Foreign Institutional Investor (FII) may enter into a forward contract with rupee as one of the currencies with an authorised dealer in India to hedge its exposure in India,

Provided that -

1. the value of the hedge does not exceed the current market value in respect of investments in debt instruments,

2. the value of the hedge does not exceed 15% of the market value of the equity as at the close of business on 31st March 1999, converted at the rate of US $ 1= Rs.42.43 plus the increase in market value/inflows after 31st March 1999 provided that the forward cover once taken shall be allowed to continue as long as it does not exceed the value of the underlying investment,

3. forward contracts once cancelled shall not be rebooked but may be rolled over on or before the maturity,

4. the cost of hedge is met out of repatriable funds and/or inward remittance through normal banking channel,

5. all outward remittances incidental to hedge are net of applicable Indian taxes.

2. A non-resident Indian or Overseas Corporate Body may enter into forward contract with rupee as one of the currencies, with an authorised dealer in India to hedge;

1. the amount of dividend due to him/it on shares held in an Indian company;

2. the balances held in Foreign Currency Non-Resident (FCNR) account or Non-Resident External Rupee (NRE) account,

3. the amount of investment made under portfolio scheme in accordance with the provisions of the Foreign Exchange Regulation Act, 1973 or under notifications issued thereunder or is made in accordance with the provisions of the Foreign Exchange Management (Transfer or issue of Security by a Person Resident outside India) Regulations, 2000 and in both cases subject to the terms and conditions specified in the proviso to paragraph 1 of this Schedule.

2A . A non-resident Indian may, subject to conditions prescribed by the Reserve Bank of India from time to time, enter into cross currency (not involving the rupee) forward contracts to convert the balances held in FCNR (B) accounts in one foreign currency to another foreign currency in which FCNR (B) deposits are permitted to be maintained.

3. Reserve Bank may, on application, allow a person resident outside India to purchase a forward contract to hedge his investment made since 1st January 1993.

3A. A person resident outside India may subject to conditions prescribed by the Reserve Bank of India from time to time enter into a forward sale contract with an authorized dealer in India to hedge the currency risk arising out of his proposed foreign direct investment in India.

3B. A person resident outside India having Foreign Direct Investments in India may, subject to the condition that forward cover shall be taken only after the rate has been approved by the Board, enter into forward contracts with rupee as one of the currencies to hedge the currency risk on dividend receivable by him from the Indian company.

Reserve Bank may, on an application made in accordance with the procedure specified in Schedule III, permit subject to such terms and conditions as it may consider necessary, a person resident in India to enter into a contract in a commodity exchange or market outside India to hedge price risk in a commodity .

1. A person resident in India , engaged in export-import trade ,who seeks to hedge price risk in respect of any commodity including Gold, but excluding oil and petroleum products, may submit an application to the International Banking

i) A brief description of the hedging strategy proposed ; namely :-

1. description of business activity and nature of risk;

2. instruments proposed to be used for hedging ;

3. names of commodity exchange and brokers through whom the risk is proposed to be hedged and credit lines proposed to be availed. The name and address of the regulatory authority in the country concerned may also be given ;

4. size/average tenure of exposure and/or total turnover in a year , together with expected peak positions thereof and the basis of calculation.

ii) copy of the Risk Management Policy approved by the Management covering:

1. risk identification,

2. risk measurements,

3. guidelines and procedures to be followed with respect to revaluation and/or monitoring of positions,

4. names and designations of the officials authorised to undertake transactions and limits.

iii) Any other relevant information.

2. Authorised dealer after ensuring that the application is supported by documents indicated in paragraph 1, may forward the application with its recommendations to Reserve Bank for consideration.

An authorised dealer in India may remit outside India foreign exchange in respect of a transaction, undertaken in accordance with these Regulations, in the following cases, namely;

1. option premium payable by a person resident in India to a person resident outside India ,

2. remittance by a person resident in India of amount incidental to a foreign exchange derivative contract entered into in accordance with Regulation 4,

3. remittance by a person resident outside India of amount incidental to a foreign exchange derivative contract entered into in accordance with Regulation 5,

4. any other remittance related to a foreign exchange derivative contract approved by Reserve Bank.

¹Foreign Exchange Derivatives Market in India - Status and Prospects by Neeraj Gambhir & Manoj Goel ICICI Bank Ltd.