Forex derivative rules set for rejig

Written by Sunny Verma | New Delhi | Updated: Jun 30 2010, 08:05am hrs
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The Reserve Bank of India (RBI) is finalising far-reaching changes to foreign exchange derivative guidelines to allow importers and exporters to write and sell put options and earn premium on them. A put option gives its buyer the right but not the obligation to sell a specified amount of an underlying asset at a set price within a specified time.

RBI has also dropped an earlier plan to ban zero-cost structures the most popular derivative product in corporate India. The new norms are expected to be notified soon.

Allowing exporters and importers directly in forex market and the leeway to offer zero-cost structures are moves aimed at expanding the size of the forex derivatives market. The over-the-counter (OTC) forex market has about $13 billion transactions a day. Last year, it used to be about $18 billion. Activity is down this year due to the slowdown in global trade and fall in the balance of payment deficit, said Golaka C Nath, senior vice-president, Clearing Corporation of India.

When financial markets started collapsing in the wake of the Lehman Brothers bankruptcy in September 2008, small and medium enterprises suffered massive losses on their holdings of zero-cost forex structures as their hedges were too low to make up for the market volatility. This led to a demand from several sections to ban the product. An official connected with the exercise said RBI has taken the view that while the scope for excess leverage should be curtailed, the products need not be banned from the OTC market. An OTC market is basically an underlying/hedging/delivery-based market, where participation is allowed only to customers having an underlying foreign currency exposure.

RBI had issued draft guidelines on OTC forex derivatives in November 2009 and final norms were expected by June-end. Many companies sought continuation of the zero-cost derivatives in their inputs to RBI.

In a zero-cost structure, while a client buys a structure after paying a premium, it simultaneously sells a structure to the bank for a premium, thereby nullifying the cost of the derivative,said KN Dey, director, Basix Forex & Financial Solutions.

As per RBI guidelines, a corporate cannot be a net receiver of the premium, but a bank can. A corporate should not enter into a zero-cost structure because these products multiply the risk instead of mitigating them. If a company can pay the premium, it should go for the plain-vanilla option where the maximum loss is the premium paid, Dey said.

Companies buy option contracts to hedge their underlying foreign currency exposure. Like a put option, a call option gives its buyer the right but not the obligation to buy an asset in a similar manner. In a zero-cost structure, the bank sells a call option to the company and the company sells a put option to the bank.

Suppose I want to buy at Rs 40, feeling it will go to Rs 35, I buy a put option at Rs 40 and pay 2% premium. If I dont want to pay this premium, then I buy call options. In case of multiple call options, these are called 1:2, 1:3 call options. This expands the leverage. Because of the built-in leverages in the contracts, there is a problem, explained a forex dealer.

The RBI move to curb leveraging will be a positive development, he said, adding companies buying zero-cost derivatives should be asked to put in place sound risk management systems. Unlike banks, corporates do not have the capacity to follow mark-to-market accounting on the options that they sell to banks. Banks can do reverse hedging in case their bets go wrong, he said.

In its November 2009 draft, RBI had said that companies can write covered call and put options. However, it said the facility of zero-cost structure would be withdrawn.

Importers and exporters having underlying unhedged foreign currency exposures in respect of trade transactions, evidenced by documents (firm order, letter of credit or actual shipment), may write plain vanilla standalone covered call and put options in cross-currency and receive premia, the draft had said.