Cashing in on currency

Written by Viveat Susan Pinto | Updated: Aug 28 2008, 07:27am hrs
The move to introduce exchange-traded currency futures has been long overdue. It was in 2007 that a panel appointed by the Reserve Bank of India (RBI) had recommended that trading in currency futures should be introduced at dedicated exchanges. After all, the sign of an evolving economy, it reasoned, was the existence of both a spot and futures marketsomething that can be found in equities and commodities here. So, why not currency

It took almost a year for things to fall in place. But they have finally. Detailed guidelines for setting up a currency futures market have been put in place by RBI and the Securities and Exchange Board of India (Sebi) following the tabling of a recent report by a standing technical committee comprising members of the two bodies.

Already three exchanges Multi-Commodity Exchange (MCX), National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) have applied to Sebi to start operations in currency futures. Of the lot, NSE will be the first to go live with trading sessions in currency futures commencing on August 29.

The implications of this for corporate India are many. For one, companies now have an additional tool available to them to hedge their underlying currency exposure. As N S Venkatesh, managing director and chief executive officer, IDBI Gilts, says, This is a welcome move because it opens up the market. There will be greater participation of players and it will bring about more liquidity. Says B Prasanna, managing director and chief executive officer, ICICI Securities Primary Dealership Ltd, I think it is a boon for the small and medium companies. Even high net worth individuals would benefit from it.

For corporates, especially in the SME segment, that are all reeling under the twin impact of inflation and high interest rates, this is good news indeed. Most companies, big and small, hedge their underlying currency exposure by getting into forward contracts with banks. These are basically over-the-counter (OTC) traded contracts where a company can buy or sell a currency at a future date based on a predetermined or pre-agreed price. It is a large market estimated at about $8-10 billion in India when at its peak from October to March, barring December. The size of the market is about $4-5 billion on an average. But the very nature of the market leaves little room for transparency between players or participants.

Based on their individual relationship with banks, most corporates get quotes from them. The quote here is nothing, but the price at which they can buy or sell the currency at a future date. This is determined with the help of a number of factors including the demand-supply position of the currency, interest rate differentials and so on. But what makes the process a bit opaque is that there is no standard mechanism to discover price. This means that pricing can be a bit arbitrary with banks giving the best quotes to their most favoured clients, usually large corporate houses, choosing to ignore the rest. As Seshagiri Rao, director, finance, JSW Steel, says; As a business plan, we are never dollar short, but long. It means our exports are more than our imports. We cover about 50% of our net dollar positions as a result of this. And yes, we do get good quotes from banks.

For large importers too, the situation is no different as they get favoured status from banks keen to retain their business. Bharat Petroleum Corporation Ltd (BPCL), for instance, is a large importer of crude like other domestic oil and gas companies. Its director, finance, S K Joshi, says, We have a huge dollar exposure on account of our imports. Our risk advisory team looks at how we can cover it. But yes, large firms do get the benefit of good quotes from banks, which may not be the case with small and medium companies. V Kumaraswamy, chief financial officer of JK Paper Ltd, an importer of pulp for its packaging board business, says, We are advised by various banks. I dont find a problem. It is fairly competitive in my opinion.

Though these executives, and indeed, most in large firms, are fairly comfortable with the existing system that is not the case with companies with a small turnover of Rs 100 crore or so. For them, currency futures is a much better way to hedge their underlying exposure because the costs involved are not steep. Moreover, the process is fairly simple, and above all, the price discovery mechanism is standardised over an exchange. This makes the system transparent, as pointed out by Apurva Mehta, associate director, business advisory services, KPMG. Quotes will be readily available on the exchange, he says. This will facilitate faster entry and exit of players as opposed to forward contracts, where due diligence tends to delay matters altogether.

As a banker with a nationalised bank explains, Banks have to undertake a lot of documentation work to determine whether the company is in a position to settle the contract or not. In short, there is a settlement risk involved, which has to be mitigated for the process to move forward.

But of all this is merely part of the subject as to why the introduction of currency futures is so relevant and important to corporate India. Observers say that its introduction will pave the way for the entry of the more sophisticated currency options tool in the country. By some estimates it could be as early as next year. Says Venkatesh of IDBI Gilts, Most developed markets have moved in that manner. Youve first had currency futures, then options.

At the moment, Indian companies, especially the large ones, that go in for borrowings abroad have to rely on the overseas offices of foreign banks to hedge their exposure using currency options. It is, in other words, an offshore market rather than an onshore market, which makes it rather circuitous for many companies. If currency options are permitted here, it would definitely help, says a banker on condition of anonymity.

Worldwide, the currency options market is a fairly evolved one and for India to come to that level would take some time even if the device is introduced some time in the future here. It is, for the record, not unlike stock options. The only difference being that the underlying asset in a stock option is equity, while it is foreign exchange in a currency option. Basically, a currency option is an instrument or device that gives the buyer (of the option) the right but not the obligation to enter into a contract with a seller. So, the buyer has a downside protection against risk and an upside benefit from favourable movement of the underlying currency. Naturally, companies would want to take advantage of this, if it were introduced in the domestic market. I see it as a matter of time before it finally is, says the chief executive of a company. Adds Mehta of KPMG, Futures in a sense is an intermediate solution, a middle path to a sophisticated options market on one hand and a plain-vanilla forwards market on the other.

Even as currency futures paves the way for currency options in the near term, it is likely to create backward linkages with the bond and interest rate futures markets. These linkages are very important in my opinion because the market will grow as a result of it, says Venkatesh of IDBI Gilts. One segment will be able to drive volumes to another and vice-versa. Says Chiragra Chakravarty, principal consultant, PricewaterhouseCoopers, Liquidity will be on the higher side as a result of this.

What all of this implies is that companies will be better equipped to handle not only currency risk as a result of their foreign exchange exposure, but also interest rate risk via linkages between currency futures, bonds and interest rate futures. The latter, for the record, is a futures contract based on an inter-bank deposit or an underlying debt security such as bonds, treasury bills, notes and government securities. It is a hedging device used by firms to help manage their exposure to interest rate fluctuations. The value of the contract incidentally goes up and down in an inverse proportion to changes in interest rates.

All this, say experts, is a step towards a freer and more developed economy. Policy makers have had an eye on this. Currency futures is widely believed to be a precursor to full convertibility of the rupee on the capital account. If that happens, corporate India would be truly unshackled.