Managing Risk in Forex Business- Hedging Instruments FED,CO,RBI FEMA EVENT AT BHILWARA AUGUST 26, 2013
May 26, 2015
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