Forex derivatives surfaced as a contentious issue for Indian corporates and banks two years ago and have grown more menacing with each passing day. In certain extreme cases, the companies involved have even had to shut down, leading to a highly chaotic environment.
Section 45 U(a) of the Reserve Bank of India Act defines “derivative” as “an instrument to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the bank from time to time.”
A foreign exchange derivatives contract means a financial transaction or an arrangement in whatever form and by whatever name called, whose value is derived from price movement in one or more underlying assets, and includes a transaction which involves at least one foreign currency other than the currency of Nepal or Bhutan.
It is pertinent to note here the relationship between the forex and forex derivatives in order to understand the implications of the two.
The genesis of the problem, to my understanding, stems from the steep movement of the dollar vis-a-vis the rupee in a short time span —- it fell to as low as Rs 39 per dollar and shot up to Rs 52 in less than a year’s time.
During 2007, companies entered into derivative structures to reduce their interest costs and to protect their top lines by safeguarding export receipts. Many companies had gone for dollar loans also, as all export-oriented firms have foreign exchange exposure. The appreciation of the rupee eroded the revenues and profits of exporters as they made fewer rupees for every dollar earned abroad.
On the other hand, they had to service the dollar loans, on which they incurred a higher interest outflow.
To offset the losses due to the rupee appreciation, corporates entered into derivatives trade. One popular option was a currency swap in the Japanese yen or the Swiss franc, with embedded option protection. The deal was structured in such a way that the option protection knocked out (disappeared) if the dollar depreciated beyond a point against the franc/yen.
The choice of Japanese yen or the Swiss franc was natural since these were considered the most stable currencies against the dollar. In the last 25 years, for instance, the Swiss franc has never moved below 1.11 to the dollar and hence corporates hedged the swap by buying options where the knock-out will get activated if the Swiss franc moved below 1.10 to a dollar.
Corporates made money on these positions last fiscal, boosting their other income and profits. The problem began when the dollar began to depreciate against all currencies, including the yen and the franc.
Graphic shows the value of 100 units of each currency in 2002 as on October, 2009 (with June 2002 as the base year.)
The US dollar depreciated nearly 35% when compared to the euro, Japanese yen and Canadian dollar. While it depreciated more than 40% against the Australian and New Zealand Dollar in these 7-8 years. Even against the South African rand and Swiss franc, it fell 40%.
Further, in-depth analysis of dollar when compared with other global currencies on a longer time span of over 7-8 years shows how the US dollar has depreciated up to 42% as compared with other currencies, whereas in India it has depreciated only around 5%.
I think it is here that the clue lies as to how the participants in the derivatives trade got trapped, based on the historical movement of the dollar over a seven-year time period.
The Indian forex derivatives market is still in its infancy, though the growth potential is huge. The development of a vibrant forex derivatives market in the country would critically depend on the growth in the underlying spot/ forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure.
Factors such as market liquidity, investor behavior, regulatory structure and tax laws will have a heavy bearing on the behaviour of market variables. Increasing convertibility on the capital account would accelerate the process of integration of Indian financial markets with international markets.
Introduction of derivative products tailored to specific corporate requirements would enable corporates to completely focus on their core businesses and de-risk the currency and interest rate risks while allowing them to gain despite any upheaval in the financial markets. Increasing convertibility on the rupee and regulatory impetus for new products should see a host of innovative products and structures, tailored to business needs.
The possibilities are many and include INR options, currency futures, exotic options, rupee forward rate agreements, both rupee and cross currency swap options, as well as structures composed of the above to address business needs as well as create real options.
In order to develop this critical market, it is important to see how effectively we can address the present issue plaguing the Indian corporate and banking sector. If we can address these issues, these forex derivative instruments can truly achieve their intended purpose acting as insurance for hedging purposes by the Indian corporate world.
The writer is a former president of the Institute of Chartered Accountants of India and an educationist. Views are personal.
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