Management of Risks of Foreign Exchange Marke
Foreign Exchange Derivatives Market in India (Part:2)

Other derivatives product
Foreign currency - rupee 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 un-expired maturity of the underlying loan

Outlook: Some proposed products

Finally some innovative products may be introduced which satisfy specific customer requirements. These are designed from the cash and derivative market instruments and offer complex payoffs depending on the movement of various underlying factors. Some of the examples of these products are provided below:

1. Accrual forward:
   With an accrual forward, for each of the daily fixings up to expiry that spot remains within the range, the holder gets longer 1 unit of USD/INR at the Forward Rate. For example, for each of the daily fixings up to expiry that spot remains within the range let us say 48.50 to 48.60, the holder accrues 1 unit at the forward rate of 48.56.

2. Enhanced accrual forward: Enhanced accrual forward is similar to accrual forward, but this contract has two forward rates, which apply for different ranges. For example, Accrue long 1 unit per fixing at forward rates of 48.56(Range 1 - 48.50 to 48.60) or Long 1 unit per fixing at 48.47(Range 2- below 48.50). So for each of the daily fixings up to expiry that spot remains within the 48.50 - 48.60 range the holder accrues 1 unit at 48.56. For each of the daily fixings up to expiry that spot is below 48.50 the holder accrues 1 unit at 48.47. If spot is ever above 48.60 then nothing will be accrued on that day. Note that the two ranges do not overlap, so the holder will never accrue more than 1 unit per fixing.

3. Higher yield deposits: This product can be developed to offer a comparable higher yield than on a traditional Rupee money market deposit.

   Exercise price : 48.80 per 1 USD
   Instrike: : 48.70 per 1 USD

   There are three possible scenarios at maturity:

   • If spot never trades at or beyond the instrike before expiration, the investment plus interest at certain rate ’r’ will be paid in rupee.

   • If spot trades at or beyond the instrike before expiration and closes above the exercise price, the investor is paid the invested capital plus interest ’r’ paid in rupee.

   • But if spot trades at or beyond the instrike before expiration and closes below the exercise price, the investor is paid in USD. The sum paid in USD corresponds to the amount of invested capital plus interest of ’r’ converted at the exercise price.

Conclusion

The Indian forex derivatives market is still in a nascent stage of development but offers tremendous growth potential. The development of a vibrant forex derivatives market in India would critically depend on the growth in the underlying spot/forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure. Factors such as market liquidity, investor behavior, regulatory structure and tax laws will have a heavy bearing on the behavior of market variables in this market.

Increasing convertibility on the capital account would accelerate the process of integration of Indian financial markets with international markets. Some of the necessary preconditions to this as suggested by the Tarapore committee report are already being met. Increasing convertibility does carry the risk of removing the insularity of the Indian markets to external shocks like the South East Asian crisis, but a proper management of the transition should speed up the growth of the financial markets and the economy. Introduction of derivative products tailored to specific corporate requirements would enable corporate to completely focus on its core businesses, derisking the currency and interest rate risks while allowing it to gain despite any upheavals in the financial markets