OTC Forwards and Options - In Practice

Foreign Exchange Management involves a combination of hedging as well as profit making at the opportune time (subject to permission by regulator). Unless a country has pegged the domestic currency in terms of the foreign currency, currency exposure is bound to play around the bottom-line. In emerging markets like India which are dominated by more active FII (Foreign Institutional investment) than Foreign Direct Investment (which is inherently permanent in nature) the job of a finance manager is like a tight rope walk which can either elevate him to the highest pedestal or dig his grave.

More common ways of forex hedging nowadays are Forwards and Options which are still within the sphere of understand ability of a layman. Forwards are contracts outside the stock exchange and mostly through Bankers who are authorised dealers of the RBI. Similarly options can also be traded with a Banker. The basic requirement for a finance manager is to have proper forecast of foreign currency cash inflows and also the reconciled list of outstanding forwards and option contracts with each of his banker and their respective maturity dates. It will only help to avoid frequent cancellation of contracts and bearing the related costs charged by the Banker. EEFC (Exchange Earner foreign currency) account facility enables holding the foreign currency receipts as such until they can be favourably exchanged in the market. This account can be used for making import payments directly as well unless they have been specifically earmarked for some forward deal. The normal action pattern (in case of exports) is to sell at spot when the foreign currency is quoted at forward discount and enter into forward deal when the foreign currency is quoted at forward premium. It is the other way around in case of imports. In case the finance manager feels that the rates on the expiration date will not favour him, he can choose to cancel the contract at any time before the expiry.

In practice, bankers offer forwards in two categories namely 1) Underlying agreement and 2) Past performance criteria. Since the Indian foreign exchange regulations require the collection of export receipts within 1 year (6 months for imports), it is not theoretically possible to have an underlying contract expiring later than 1 year. Also the relevant regulation says that the maturity of the hedge contract cannot exceed the maturity of the underlying transaction. But the sweetener here is that the contracts can be rolled over with no limitations as to number of rollovers but not more than 6 month maturities every time and what will get impacted is the swap cost every time when the rollover takes place. Forward rates as we all appreciate depend upon the interest rate differential between the relevant countries on the date of the contract (Interest rate parity theory). There is no room for negotiation on the forward rates as the same is fixed in the market and we will have to accept them anyway. It is notable that as per FEMA (Foreign exchange derivative) regulations, where the exact amount of the underlying transaction is not ascertainable, the contract can be booked on the basis of a reasonable estimate. Therefore the value addition of a finance manager comes to play in fixing the quantum of currency which is the contract quantity. This is where the rollover facility comes handy since on the date of maturity the contract can be partially liquidated to the extent of actual receipt and balance can be rolled over at a swap cost.

(For reader’s recollection, the Banker enters into a swap contract with another bank which is of opposite position i.e. he will enter into an interbank forward sale contract if the customer has a forward purchase contract and vice versa. This is done for the sake of the customer and to ensure that he has the requisite currency to sell to customer on the maturity date. Swap cost is the difference between contracted rate and forward TT selling rate for the balance tenure if it is a premature cancellation or the spot TT selling rate if it is cancellation on maturity for further rollover. If it is a forward sale contract the situation can be construed accordingly. To explain with an example, if the customer wants to cancel a forward sale one month prior to expiry, the banker will charge a swap cost or credit a swap gain equal to (contracted rate - 1 month interbank forward selling rate)*contracted quantity of the currency.)

The other alternative is to rebook the same forward transaction after cancelling it. Currently the RBI regulations permit both importer as well as an exporter to rebook forwards of any tenor. But they can do so only for deals covering specific underlying transactions and not those based on past performance; the reason being non availability of documents. The difference between a roll over and rebooking is simple. In the former case only a portion of the contract is liquidated and the balance continues whereas in the latter the entire contract is cancelled and booked again.

Normally, there is a grace period of about 15 days from actual expiration within which the customer will have to instruct the banker either to cancel or execute, failing which the contract will get cancelled by default. The issue with this type of unilateral cancellation is the banker does not pass on any exchange gain but only the swap cost arising. But in case of any other cancellation, the banker will debit or credit the customer account with the loss or gain on cancellation. Again this gain or loss is nothing but the one arising on swapping by the banker as explained above. The same thing happens if the customer fails to submit necessary documents on the underlying exposure to the Bank within the agreed time.

Past performance criteria is a facility which allows an importer or exporter to negotiate with the Banker for forward contracts based on his past average exposure. Currently banks are permitted to allow importers and exporters to book forward contracts on the basis of a declaration of an exposure and based on past performance up to the average of the previous three financial years' (April to March) actual import / export turnover or the previous year’s actual import / export turnover, whichever is higher, subject to specified conditions. This helps to avoid multitude of underlying contracts and the time taken to monitor them. As per the current RBI Circular any amount in excess of 75% of the eligible amount calculated as above will have to be performed and cannot be cancelled as such. We need to be careful while rebooking or rollover because the eligible limit will be reduced accordingly. One has to maintain proper track of the utilisation of eligible limits.

As per an RBI circular an importer is allowed to hedge his economic exposure arising out of customs duty payment on imports. These contracts shall be held till maturity and cash settlement would be made on the maturity date by cancellation of the contracts. Forward contracts covering such transactions once cancelled are not eligible for rebooking. However, in case of changes in the rate of customs duties, due to Government Notifications, importers may be allowed to cancel and/or rebook the forward contracts before maturities.

Forwards vs. options in Reality

Option contracts were permitted in India for the first time by RBI in the year 2003 and since then the volumes are brisk. As per the latest regulation, a foreign exchange option contract cannot be entered into by a person who has a foreign currency exposure worth less than Rs.1000 crores i.e. summing up exports and imports. Options can also be taken based on Past performance but there is no rollover facility like in Forward deals. OTC (Over the Counter) Derivatives are regulated by an organisation called ISDA (International Swaps and Derivative association) which sets out the master agreement. All Banks adopt this agreement and the confirmation format. But the risk associated with the modern day option with a Bank may be more than the forwards if the customer has not understood the obligation clause discussed below.

To substantiate this , let us consider a typical put option in foreign currency with a Banker which reveals that the customer has the right to sell say $10000 at Rs.45 per $ on a specified expiration date when the spot price is lower than Rs.45 per $. But on the flip side it also says that the customer is obliged to sell say $20000 to the Bank if the spot price is higher than Rs.45 per $. The agreement also tabulates various scenarios with higher spot prices showing the possible financial loss to the customer. As such the Customer is required to maintain requisite collateral with the Banker. Now, this is not a case where only the seller (i.e. bank) will face unlimited loss. In fact it seems that the customer bears equal risk as that of the Banker. The following table illustrates the likely outcome of the above situation on expiry.

To sum up, cost of options can be too high. In fact many customers have lost money on such counts and dragged the banker to courts. But all said and done, nothing works if the customer had not taken expert advice or properly comprehended the agreement before signing the deal confirmation.

Forwards and options are one among such derivatives whose lack of understanding or overconfidence of the counterparty can lead to serious losses. In the West, derivatives have been one of the major factors for market crashes and depression. Remember the Credit Default swaps (CDS) in 2007 which played havoc alongside as the corporate default rate increased. In those days the banks went merry collecting huge premiums on the CDS with regard to borrowings of big corporate. During Subprime crisis, more big companies started defaulting and the product lost value. A Derivative will not survive if the underlying cannot and hence thorough knowledge of the underlying asset as well as the Derivative product can only save the investor. The principle of ‘Caveat Emptor’ is not only relevant for real properties but also more importantly for these products.

“When you have got an elephant by the hind legs and he is trying to run away, it's best to let him run” - Abraham Lincoln

"It's like betting on a sports event. The game is being played and you're not playing in the game, but people all over the country are betting on the outcome."  -  Andrea Pincus, partner at Reed Smith LLP during the CDS crisis