Managing Risk in Forex Business- Hedging

Instruments

FED,CO,RBI

FEMA EVENT AT BHILWARA

AUGUST 26, 2013

Two issues

Derivatives (Currency) as Risk Management Tool

Risk Management of Derivatives (Currency)

So why is the first required?

First IssueDerivatives (Currency) as Risk Management Tool

Derivatives as instrument of Risk Management do not eliminate risk from the market or the system

They are only a medium to transfer risk from a person who is risk averse and does not want to take risk (hedger) to a person who is prepared to take the risk.

First IssueDerivatives (Currency) as Risk Management Tool

What are derivatives?Types of derivative contractsHow to manage risk with derivatives? What type of risks are managed?Extant guidelines of currency derivatives in IndiaCrucial issues Challenges ahead

What are derivatives?A derivative instrument is a financial instrument whose

performance is based on (derived from) the value of an underlying variable.

The variable can be anythingPrice/Value of something

Foreign Exchange – Forex derivatives Interest Rates – IRDs Commodity – Commodity Derivatives Equity – Equity Derivatives

CreditWeather etc.

Types of derivatives – Basic OTC derivatives

ForwardsOptionsSwaps

Exchange traded derivativesFutures

Options on futuresOptions

Need for DerivativesRisk – Is the probability of loss due to uncertainty in

realisable value of an assetIncreases with increased volatility in the price/value of any

underlyingDerivatives help in bringing certainty i.e. you exchange

certainty for uncertainty Each risk element can be managed separately and sold to

willing partiesIdentify the instrument that is most appropriate for the risk

How derivatives help in managing risk?Facilitates isolation of risk elements

Each risk element can be managed separately and sold to willing parties

Identify the instrument that is most appropriate for the risk

How to manage risk with derivatives?Identify the risk

Quantify the risk

Identify the instrument that is most appropriate for the risk

Indian forex marketOne of the fastest growing markets in the worldBIS Triennial Survey indicate the global daily average turnover

in USD – INR pair at USD 36 billion in April 2010, when compared to USD 17 billion in April 2007

The daily average turnover in INR accounted for 0.9% of the global turnover, as compared to 0.7% in 2007

The daily average turnover in June 2013 close to USD 52 billion in the OTC market and around USD 8 billion in the exchanges

Large flows are absorbed seamlessly Customers have wider choice of instruments and markets

Regulatory ProvisionsSection 45-U of the RBI Act, 1934(amendment 2006)-

defines a derivative

Section 45-V of the RBI Act, 1934(amendment 2006)- validity of derivative contract

Section 45-W of the RBI Act, 1934(amendment 2006)-empowers RBI to regulate such contracts

Cont..Notification 25 of 3rd May 2000 deals with Foreign

Exchange Derivative Contract regulationsSubsequent revisions to the notification based on

amendments to regulationsAll guidelines consolidated into a Master Circular on Risk

Management and Inter Bank Dealings (updated every July)

Comprehensive guidelines on OTC forex derivatives issued recently on 28th December 2010

Comprehensive Guidelines on Derivatives- DBOD circular dated April 20, 2007

What do the regulations stateFEMA regulations stateWho can undertake derivative transactions?

ResidentsNon-residents

Why to undertake?Hedging of risk exposuresTransformation of risk exposures – currency

What products can be used?

Cont..

Residents can enter in to forex derivatives contract only if they have exposure to the forex markets i.e. are exposed to fx rate risk

Mainstay : presence of an underlying exposure

For hedging their exchange rate risk only

Underlying principles

Presence of an underlying exposure is mandatory Actual Underlying exposure as demonstrated by supporting

documentationPotential exposure for exporters and importers pending

receipt of actual documentationDeclaration of an exposure for facilitating hedging without

production of the documentsEconomic exposure where indirectly exposed to exchange rate

risk Rupee exposures where a user can transform his long-term

rupee liability to forex liability

Derivative Instruments allowedForwardsForeign Currency – Rupee OptionsCross currency optionsSwaps Currency Futures (Started from August 2008)Exchange traded Currency Options( Started in October

2010)

Cont..Most of the instruments have been allowed for Residents

For non-residents – only forwards and foreign currency-rupee contracts are allowed

For ECB underlying – transactions not involving rupee Interest Rate Swap / Currency Swap / Coupon Swap / Foreign Currency Option / Interest Rate Cap or Collar (purchases) / Forward Rate

Agreement (FRA)

Exchange Traded Futures and Currency Options

Regulated jointly by SEBI and RBIExpanded menu of exchange traded toolsFutures permitted in four currency pairsPlain vanilla Currency Option on spot USD/INR European Call and Put OptionsOnly residents are permitted to participate in the currency

segments of the stock exchanges

Currency Futures- objectives Provide an additional hedging tool Development of domestic forex marketAllowing transactions beyond hedging, move towards

fuller capital account convertibility Provide a platform to retail segment that ensures efficient

price discovery Increasing integration and openness of the Indian

economyDemand from market participants and industry

associationsRecommendations of various Committees

Issues in OTC derivatives

Losses to the users, both on complex and plain vanilla products

Use of exotic derivatives, without clearly establishing the suitability and appropriateness

Leverages in products and in underlying exposuresDerivative products have been used as a profit management

tool than a risk mitigant Transformation of Rupee liability, without natural hedges or

proper appreciation of downsides

Approach to address the concerns Leverage – establishing the exposure and limiting to plain

vanilla products Certification by statutory auditors and self declaration Cost reduction structures, only with safeguards

o Net worth/Turnover of the corporate, o Compliance with accounting/disclosure standards, as

stipulated under AS 30 and AS 32 o No leverage structures o No exotic productso Risk management capabilities

Thank You