Mumbai: In a move that could change the face of over-the-counter derivatives market in India, the Reserve Bank of India, or RBI, on Thursday proposed to allow importers and exporters to write and sell “put” options both in foreign currency-rupee and cross-currencies and earn premium on them.
The Indian central bank has also proposed that banks should be allowed to offer plain vanilla cross-currency options to resident Indians who need to transform their rupee liability into foreign currency liability.
RBI has put up the draft guidelines on its website and is seeking comments on the proposals for over-the-counter foreign exchange derivatives and hedging commodity price risk and freight risk by 15 December.
Currency deal: RBI has put up the draft guidelines on its website and is seeking comments on the proposals for over-the-counter foreign exchange derivatives and hedging commodity price risk and freight risk. Amit Bhargava / Bloomberg
“The objective seems to be sensitizing the population to get familiarized with derivatives with an eventual goal to rupee convertibility,” said Harihar Krishnamurthy, head of treasury at First Rand Bank.
The buyer of a “put” option gets the right but not the obligation to sell a specified amount of an underlying asset at a set price within a specified time.
Similarly, the buyer of a “call” option has the right but not the obligation to buy an asset in a similar manner.
When a company enters into an option transaction with a bank, the structure is such that the bank sells a call option to the company and the company sells a put option to the bank. This nullifies the cost of entering into such a transaction. This is also known as zero-cost structure for which no premium income is earned.
Companies are not allowed to float a stand-alone put option on its own. It is only allowed as a part of the zero-cost structure, according to S. Rajendran, general manager (treasury), Union Bank of India.
If the RBI proposal becomes a norm, companies can float stand-alone put options on any currency. Since a put option exposes the issuer to risks, the issuer can charge premium for it. These options should be “covered”, or the exporter or importer should have an underlying asset before it can float this kind of option.
According to foreign exchange dealers, the zero-cost option is not fully zero cost and is quite complicated. “RBI may want to make the structure simple. When you buy an option it’s your view. You may not have to enter an opposite transaction unnecessarily,” said Rajendran.
RBI said the option must be covered or must have underlying assets.
“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 stand alone covered call and put options in cross-currency and receive premia,” the draft guidelines said.
Since the counterparty to any foreign exchange transaction is a bank, the onus is on the company to satisfy the bank that it has sound risk management systems in place.
Banks will also be allowed to offer plain vanilla cross-currency options for those people who want to transform their rupee liability to a foreign currency liability.
How will that work? Let’s assume that a person has taken a yen loan and is paying through rupees in India.
In this case, the bank needs to buy dollars using the customer’s rupee resources and, at the second stage, yens using the dollar. This exposes the customer to double currency risk. The cross-currency options minimise the risk of conversion.
“Before offering the product, the maximum possible loss/worst downside, under various scenarios is to be quantified and conveyed to the customer in the term sheet,” the draft guidelines said.
Another important recommendation that RBI proposed is to allow special dispensation to small and medium enterprises to book forward foreign exchange contracts without production of underlying documents for hedging their foreign exchange exposure.
The draft also proposed that resident individuals be allowed to self declare and opt for hedging facility for any actual or anticipated remittances up to $100,000 (Rs46.5 lakh) without producing any underlying documents.