Key Changes in FX Derivative Guidelines
RBI released final comprehensive guidelines on hedging with foreign exchange derivatives. The guidelines would be applicable from 1st February 2011. Key changes in the forex derivative hedging & their implications are given below:

Cross Currency Options (Not involving rupee)
  • Banks can only offer plain vanilla European Options.
  • Exotic options like Barriers & Binary not allowed anymore.
Foreign Currency - INR Swaps (FCY-INR Swaps)
  •  INR - FCY swap (to move from rupee liability to foreign currency liability) may be restricted to listed companies or unlisted companies with Rs.200 cr minimum net worth.
Cost Reduction Structures
  • Range Forwards, Call Spreads, Put spreads etc permitted only to companies with minimum net worth of Rs.100 cr.
  • Adoption of Accounting Standards 30 and 32.
  • Having a risk management policy with the specific clause allowing these structures.
  • Exotic barriers & leverage structures not permitted.
  • Delta of the options to be indicated in the term sheet.
Hedging without current underlying exposure
  • There are more restrictions on hedging based on past performance. Only companies with net worth of Rs. 200 cr and exim turnover of Rs. 1000 cr will be eligible to hedge projected business based on past performance (last year turnover or average of last 3 years whichever is higher)
  • The limit will be one time limit; limit for cancelled / expired contracts will not be restored
  • 75% of the hedge contracts should be on deliverable basis
Special dispensation for SMEs
SMEs are allowed to freely book / cancel / rollover forward contract without production o0f underlying documents, to manage their exposures efficiently, subject to approval of necessary credit limits by their bankers.

Price Transparency
The pricing of all derivatives should be locally demonstrable at all times

Comments :
  • By banning exotic options like barriers, range accruals and leverages RBI has tried to clamp down on complex derivatives deals, which always faced pricing & risk management issues.
  • Companies permitted to benefit from interest rate carry by shifting from rupee liability to FCY liability through INR-FCY swaps, may not be able to hedge the derived FX exposure against Rupee (cross currency exposures can be hedged).
  • Cost reduction structures like Range forwards , Put / Call spreads & Seagulls have been permitted only to the companies with a minimum net worth of Rs.100 cr and adoption of AS 30/32. RBI has not banned zero-cost structures, even though some of the medium and long term zero cost structures had recently caused derivative losses to several companies, provoking legal action against the counter-party banks..
  • We may note here that structures like Put / Call spreads do reduce the hedging costs and they never result in negative MTM unlike range forwards & seagulls, and hence are relatively less risky. .
  • RBI has made it compulsory to indicate the delta of the structure in the term sheet for cost reduction option structures. Delta is the sensitivity of the option price to a change in the underlying. For greater transparency, RBI should have also made it obligatory for the banks to furnish generic options, with break up of the structure in the term sheet as against the prevalent practice of indicating only pay-off against spot on maturity.
  • RBI continues to restrict cancellation and rebooking of currency and interest rate swaps, hedging FC loan liability against FC-Rupee risk, while there is no such restriction on cross-currency swaps.
  • RBI should have avoided placing multiple restrictions on product-wise eligibility of users, such as minimum net worth of Rs. 100 cr at one place, net worth of Rs. 200 cr at another place and net worth of Rs. 200 cr + exim turnover of Rs. 1000 cr at yet another place. There is much scope for simplification of the guidelines.