Management of Risks of Foreign Exchange Market
Foreign Exchange Derivatives Market in India

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

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:

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:

1. Residents: Genuine underlying exposures out of trade/business

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

   • Balances in EEFC accounts

2. Foreign Institutional Investors:

   • 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

3. Non-resident Indians/ Overseas Corporates:

   • Dividends from holdings in a Indian company

   • Deposits in FCNR and NRE accounts

   • Investments under portfolio scheme in accordance with FERA or FEMA

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 1year, 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.

The liquidity in the Indian forwards market is mainly for the end maturity contracts, where the bid-offer spread is also low. Standard maturity contracts like for 3 months and 6 months are not quoted in the inter bank markets. Hence, the cost of entering into a standard maturity contract is much higher as compared to a month end contract. Other eccentricities such as the tenuous links with the interest rate differential still prevail in a market driven primarily by supply/demand. The forward premia has been gradually aligning to fundamentals of "interest rate parity", a process that should accelerate with increased convertibility on the capital account. One of the drivers for this could be that the integration between the domestic market and the overseas market has been facilitated now by allowing ADs to borrow from their overseas offices and invest funds in overseas money market up to 25% of Tier I capital.

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.

As mentioned earlier, Indian forwards market is relatively illiquid for the standard maturity contracts as most of the contracts traded are for the month ends only. One of the reasons for the market makers’ reluctance to offer these contracts could be the absence of a well- developed term money market. It could be argued that given the future like nature of Indian forwards market, currency futures could be allowed.

Some of the benefits provided by the futures are as follows:

• Currency futures, since they are traded on organized exchanges, also confer benefits from concentrating order flow and providing a transparent venue for price discovery, while over-the-counter forward contracts rely on bilateral negotiations.

• Two characteristics of futures contract- their minimal margin requirements and the low transactions costs relative to over-the-counter markets due to existence of a clearinghouse, also strengthen the case of their introduction

• Credit risks are further mitigated by daily marking to market of all futures positions with gains and losses paid by each participant to the clearinghouse by the end of trading session.

Moreover, futures contracts are standardized utilizing the same delivery dates and the same nominal amount of currency units to be traded. Hence, traders need only establish the number of contracts and their price.

• Contract standardization and clearing house facilities mean that price discovery can proceed rapidly and transaction costs for participants are relatively low

However given the status of convertibility of Rupee whereby residents cannot freely transact in currency markets, the introduction of futures may have to wait for further liberalization on the convertibility front.

The Reserve Bank of India has permitted authorised dealers to offer cross currency options to the corporate clients and other interbank-counterparties 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.

RBI Regulations

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.

Outlook Rupee currency options

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. Introduction of USD-INR options would enable Indian forex market participants manage their exposures better by hedging the dollar-rupee risk. The advantages of currency options in dollar rupee would be as follows

• Hedge for currency exposures to protect the downside while retaining the upside, by paying a premium upfront. This would be a big advantage for importers, exporters (of both goods and services) as well as businesses with exposures to international prices. Currency options would enable Indian industry and businesses to compete better in the international markets by hedging currency risk

• Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures. e.g. If an Indian company is bidding for an international assignment where the bid quote would be in dollars but the costs would be in rupees, then the company runs a risk till the contract is awarded. Using forwards or currency swaps would create the reverse positions if the company is not allotted the contract, but the use of an option contract in this case would freeze the liability only to the option premium paid upfront.

• The nature of the instrument again makes its use possible as a hedge against uncertainty of the cash flows. Option structures can be used to hedge the volatility along with the non-linear nature of payoffs. Attract further forex investments due to the availability of another mechanism for hedging forex risk.

Hence, introduction of USD-INR options would complete the spectrum of derivative products available to hedge INR currency risk.

Options being over the counter products can be tailored to the requirements of the clients. More sophisticated hedging strategies call for the use of complex derivative products, which go beyond plain vanilla options.

These products could be introduced at the inception of the Rupee vanilla options or in phases, depending on the speed of development of the market as well as comfort with competencies and Risk Management Systems of market participants. Some of these products are mentioned below:

Simple structures involving vanilla European calls and puts such as range-forwards, bull and bear spreads, strips, straps, straddles, strangles, butterflies, risk reversals,etc.

• Simple exotic options such as barrier options, Asian options, Lookback options and also American options.

• More complex range of exotics including binary options, barrier and range digital options, forward-start options, etc

Some of the above-mentioned products especially the structure involving simple European calls and puts may even be introduced along with the options itself.