CHAPTER 29 DERIVATIVES 1
CHAPTER 29 DERIVATIVES INDEX Para No TOPIC Page No 29 Introduction 3 29 1 Foreign Currency Option 3 29 2 Foreign Currency Rupee Swaps 4 29 2 1 SWAPS 5 29 2 2 Currency Swaps 5 29 2 3 Interest Rate Swap 5 29 2 4 Forward Coupon Swaps 6 29 2 5 Interest Rate Caps/Collars 6 29 2 6 Forward Rate Agreement (FRAs) 6 29 3 Exchange Control Guidelines 8 29 4 Forward Rate Agreement / Interest Rate Swaps (INR) 9 29 4 1 Types of FRA/IRS 9 29 4 2 Benchmark Rate 9 29 4 3 Capital Adequacy 10 29 4 4 Exposure Limits 10 29 4 5 Documentation 11 29 5 Long Term Foreign Currency Rupee Swaps 12 29 5 1 Note 12 29 5 2 Capital Adequacy 13 29 5 3 Exposure Limits 13 29 5 4 Documentation 13 29 6 Foreign Currency Rupee Options 14 2
29 INTRODUCTION Derivatives are instruments whose value is based on or derived from prices of currencies, commodities, interest rates, share indexes etc. Financial derivatives were designed in view of the need to hedge risks caused by volatility in exchange rates and interest rates. The forward contract can also be considered as a derivative instrument as the value is derived from spot exchange and interest rates. Banks in India have been permitted by RBI to offer following products in addition to forward cover to certain specified exposures of customers to hedge their exchange risk. 29.1 FOREIGN CURRENCY OPTION A foreign currency option contract is an agreement between two parties which provides the purchaser with the right, but not obligation to buy or sell a fixed amount of currency at an agreed exchange rate known as the STRIKE OR EXERCISE PRICE. A right to buy a specified currency is known as a CALL OPTION and a right to sell a specified currency is called a PUT OPTION. A currency option protects against downside risks and at the same time, provides an opportunity to participate in profit, if the exchange rate moves favourably. Example: A customer has to make the payment of EUR 500,000 in three months but has only USD funds with him. He would like to restrict the payment to not more than USD 1.20 per EUR. Hence he buys a call option on the EUR at the exercise or strike price of USD 1.19 paying a cost (premium) of USD 0.25 (spot rate is 1 EUR USD 1.19). On due date, if the EUR is USD 1.25 he exercises the option, if it is USD 1.15 he allows the option to expire and buys EUR in the open market. When the strike price in relation to the currency market rate is favourable to the buyer, it is referred to as 'in the money, when the strike price is not favourable it would be out of the money and when the strike price is equal to currency price, it is known as 'at the money. An option which can be exercised at any time until the expiry date is called an American Option. An 3
option, which can be exercised only on expiry date, is called an European Option. RBI has permitted banks to offer Cross Currency options to customers with an exposure to exchange risks in specific transactions. The option should be written on a fully covered basis by buying an identical option for the same amount, same or favourable strike price and maturity. The option contracts are booked subject to customer's declaration that they have not already booked/will not book foreign currency forward cover/currency option for the same transaction. The option contract can be booked subject to the same being within the overall limit as specified for Forward Contracts. The customer is required to sign the International Currency Option Market Master Agreement on stamp paper as applicable for agreements and give a request letter on specific format (FEDAI approved). Copy of the request letter/agreement may be obtained from Treasury Branch, Mumbai. Option premium may be remitted without prior approval of RBI. Options should appear as a contingent item and be marked to market at periodic intervals so as to coincide with the date of revaluation of the foreign exchange position at monthly intervals. The cross currency options may be allowed to be freely booked and cancelled. RBI has also permitted the offering to customers of cost effective risk reduction strategies like range forwards, ratio range forwards and such other variables provided there is no net inflow of premium. Range forwards or Tunnel options are created by simultaneous purchase of a 'call' and sale of a 'put' (or vice-versa) at different strike prices so as to make the upfront cost zero. Ratio-range forward is an option in which the amount of 'call' and 'put' are different and are so chosen to bring the upfront cost down to the level desired by the customer. 29.2 FOREIGN CURRENCY - INR SWAPS RBI has permitted banks to arrange foreign currency rupee swaps between corporates, who have exposures arising out of these long-term foreign 4
currency commitments. Entities, who do not have any forex exposure but are willing to assume forex liability in lieu of the long term rupee liability may also become counter parties in the arrangement. Banks may enter into foreign currency rupee swaps between entities to assist the exchange of such obligations between them and absorb the residual currency/ interest mismatches within their open position/gap discipline. Definition and brief description of swap is given in para 3.B.1. The banks in India have also been permitted to offer following products to Indian corporates for hedging their foreign currency loan liabilities: i) Currency Swaps ii) Interest Rate Swaps iii) Forward Coupon Swaps iv) Interest rate cap/collars (purchase) v) Forward Rate Agreements 29.2.1 SWAPS A swap has been defined as an exchange of payments in one currency for a stream of payments in another currency over a period of time. 29.2.2 CURRENCY SWAPS Under a currency swap two counterparties agree to exchange the different currencies at the outset and repay them in the future. There may not be any exchange of currencies but only the servicing payments are swapped. A currency swap completely converts a long term liability or asset in one currency to a long term liability or asset in another currency. For Example : A company with U.S.Dollar income has borrowed in Japanese Yen for 5 years. The company enters into a swap arrangement through its bank, whereby the bank provides the Yen necessary to cover the loan liability in exchange for US Dollars which the company delivers. 29.2.3. INTEREST RATE SWAP An interest rate swap is a contract between the customer and the bank to exchange two different interest rate cash flows, one usually determined 5
on a floating rate basis and the other on a fixed rate basis. The interest rate swap enables customers to convert one kind of income/payment stream for another kind of income/payment stream. For Example : If customer has a floating rate debt and perceives interest rates moving up, the floating rate can be swapped for a fixed rate to eliminate the exposure to an increase in rates. 29.2.4. FORWARD COUPON SWAPS A coupon swap is a form of interest rate swap where there is an exchange of fixed rate for floating rate. 29.2.5. INTEREST RATE CAPS/COLLARS A Cap is an agreement between two parties which limits interest rate exposure to a maximum rate for a defined period of time. A Floor is an agreement which maintains interest rate income to a minimum rate for a defined period of time. A Collar is an agreement whereby one party buys one cap and sells one floor simultaneously so that the cap rate is higher than the floor rate. in a collar, a borrower can buy a cap (to protect against a rise in rates) and simultaneously sell a floor with a lower strike rate. The floor would result in loss of benefits of lower interest rates if the fall is below the floor strike rate. The cost of the collar for the customer is generally the premium charged for the cap and the premium received for the floor. 29.2.6. FORWARD RATE AGREEMENTS (FRAs) A forward rate agreement is a forward contract on interest rate. It allows the buyer to fix an interest rate for a specific future period, enabling him to accurately estimate the future cash flows. The FRA is used to hedge against future interest rate movements. For Example: The agreed six month LIBOR rate of interest on a FRA is 1.25%. If LIBOR is 1.35%, the bank will pay the difference 0.10% to be borne by the customer. However, if the LIBOR rate is 1% the customer will pay the 0.25 % difference to the bank. The interest cost in both the cases 6
remains at 1.25% for the customer. Before entertaining the corporate's request for hedging of the loan exposure, it is to be ensured that : - final approval for conclusion of the loan transaction has been accorded by RBI. - the notional/principal amount of the hedge does not exceed the outstanding amount of the foreign currency loan. - the maturity of the hedge does not exceed the remaining life to maturity of the underlying loan. - the hedge results on a reduction of the risk of exposure and there is no net inflow of premium direct or unpaid in cases where option components are built into the hedge strategy. - One time approval from Board of Directors of the company approving the financial limits and authorising designated officials to conclude the hedge transaction. - The terms of the hedge and eligibility of the corporate. - In cases where the transactions are booked abroad the overseas entities should be the branch of an authorised dealers in India. - Corporates submit a report showing details of the transactions concluded (booked as well as cancelled) duly certified by the authorised dealers that all conditions are complied with, to Regional Office of RBI within a week from the date of conclusion of the transaction. - Corporates submit to authorised dealers copy of a quarterly report to their Board furnishing details of the transactions and the Board resolution. An annual certificate from the statutory auditors that the company has complied with all prescribed terms and conditions. Corporates are permitted to unwind from a hedge transaction. Payment of upfront premia, if any, as well as all other charges incidental to the hedge transaction may be effected without prior approval of RBI. Hedge transactions are allowed to be put through solely for the purpose of liability management and no stand alone deals are to be permitted. 7
29.3 EXCHANGE CONTROL GUIDELINES. 29.3.1. [1]A person resident in India who has borrowed foreign exchange in accordance with the provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000, may enter into an Interest rate swap or Currency swap or Coupon Swap or Foreign Currency Option or Interest rate cap or collar (purchases) or Forward Rate Agreement (FRA) contract with an authorised dealer in India or with a branch outside India of an authorised dealer for hedging his loan exposure and unwinding from such hedges, Provided that (a) the contract does not involve rupee, (b) the Reserve Bank has accorded final approval for borrowing in foreign currency, (c) the notional principal amount of the hedge does not exceed the outstanding amount of the foreign currency loan, and (d) the maturity of the hedge does not exceed the un-expired maturity of the underlying loan, [2] A person resident in India, who owes a foreign exchange or rupee liability, may enter into a contract for foreign currency-rupee swap with an authorised dealer in India to hedge long term exposure, [3] The contract entered into under sub-paragraph 2, if cancelled shall not be rebooked or re-entered, by whatever name called. 29.3.2 [1] A person resident in India may enter into a foreign currency option contract with an authorised dealer in India to hedge foreign exchange exposure of such person arising out of his trade : Provided that in respect of cost effective risk reduction strategies like range forwards, ratio-range forwards or any other variable by whatever name called there shall not be any net inflow of premium. 8
Explanation The contingent foreign exchange exposure arising out of submission of a tender bid in foreign exchange is also eligible for hedging under this sub-paragraph. [2] A Transaction undertaken under sub-paragraph (1) may be freely booked and/or cancelled. Banks in India have been permitted by RBI to offer following products in addition to forward cover to certain specified exposures of customers to hedge their exchange risk and interest rate risks. 29.4 FORWARD RATE AGREEMENTS/INTEREST RATE SWAPS. (INR) 29.4.1 Types of FRA/IRS. Branches can undertake different types of vanilla FRA/IRS only. Swaps having explicit/implicit option features such as caps/floors/collars are not permitted. 29.4.2 Benchmark Rate The benchmark rate should necessarily evolve on its own in the market and require market acceptance. The parties are free to use any domestic money or debt market rate as benchmark rate for entering into FRAs/IRS provided methodology of computing the rate is objective, transparent and mutually acceptable to counterparties. The use of interest rates in the foreign exchange forward market as a benchmark is also permitted in addition to the existing domestic money and debt market rates. This is done with a view to provide more flexibility for pricing of the Rupee interest rate derivatives and to facilitate some integration between the money and foreign exchange markets. 9
29.4.3 Capital Adequacy For reckoning the minimum capital ratio, the computation of risk weighted assets on account of FRAs/ IRS should be done as per the two steps procedure set out below: Step 1: The notional principal amount of each instrument is to be multiplied by the conversion factor given below : Original maturity Less than one year One year and less than two years For each additional year Conversion factor 0.5 per cent 1.0 per cent 1.0 per cent Step 2: The adjusted value thus obtained shall be multiplied by the risk weightage allotted to the relevant counterparty as specified below: Banks/ All India Financial Institutions 20 per cent All others (except Governments) 100 per cent 29.4.4 Exposure Limits Branches have to arrive at the credit equivalent amount for the purpose of reckoning exposure to the corporate. For this purpose, the branches should apply the conversion factors to notional principal amounts as per the original exposure method prescribed in 29.D.3 above. The exposure should be within the sub-limit to be fixed for FRA/IRS within the overall credit limits approved in favour of the corporate as per the credit policy of the Bank and the lending norms prescribed by RBI. Due diligence should be exercised to ensure that corporate undertake FRAs/IRS only for hedging their own Rupee balance sheet exposures. A 10
certificate is to be obtained from authorized signatory/signatories of the corporate to the effect that the transactions undertaken by them are meant for hedging balance sheet exposures only i.e. The size and tenor of the transactions undertaken are not in excess of their underlying Rupee exposures. 29.4.5 Documentation. Apart from other documents stipulated by the sanctioning authority and the undertaking required to be obtained as per para 29.D.4 above, branches should obtain ISDA documentation as suitably modified to comply with the guidelines for undertaking FRAs/IRS transactions. Necessary legal advice should be obtained for finalising the ISDA documentation. The following changes should also be considered. i. In Clause 8 (a) the words "Subject to the laws and prevailing guidelines in India" may be inserted at the beginning. ii. The words "Stamp Tax" wherever appearing in the Agreement may be substituted by the words "Stamp Duty". There is a reference to Credit Support Document and Credit Support Provider in the document. In case any further documents/agreements are required to be executed under the given transactions, the provisions of the same will have to be drafted keeping in mind the prevailing laws and guidelines. However, in cases where no further documents are to be executed the reference to the same and to the provisions relating to Credit Support Default in the Agreement may be deleted. This may be done in the Schedule to the Agreement rather than the main Master Agreement. Similarly, if any, further changes are desired to be made to meet specific requirements of participants, it is desirable to do so in the Schedule rather than the main Master Agreement. Clause 13(a) of the Agreement provides that the Agreement will be governed by and construed in accordance with the law specified in the Schedule. Hence, the applicable law will have to be mentioned in the 11
Schedule to the Agreement. Participants may specify the applicable Law (e.g. Indian Law or English Law or US Law) as deemed appropriate by them, in the Schedule. It may be further clarified that the change suggested in Clause 8(a) is only clarificatory in as much as all payments would in any case be subject to any Indian Laws or guidelines. The provision made in Clause 13 regarding applicable laws and jurisdiction stipulates the law that would apply to decide any dispute between the parties. Counterparties are free to modify the ISDA Master Agreement by inserting suitable clauses in the schedule to the ISDA Master to reflect the terms that the counterparties may agree to, including the manner of settlement of transactions and choice of governing law of the Agreement. It may be mentioned that besides the ISDA Master Agreement, participants should obtain specific confirmation for each transaction which should detail the terms of the contract such as gross amount, rate, value date, etc. duly signed by the authorised signatories. It is also preferable to make a mention of the Master Agreement in the individual transaction confirmation. 29.5 LONG TERM FOREIGN CURRENCY RUPEE SWAPS Currency Swap is an agreement between two parties to exchange a stream of principal and interest payments in one currency for a stream of principal and interest payments in another currency over multiple specified periods. Long term foreign currency-rupee swaps can be used by corporate as a hedging tool facilitating switching of foreign currency liability to domestic liability and vice versa. Indian corporate which are borrowers of long term foreign currency loans and those engaged in implementing turnkey projects overseas are able to properly manage their foreign exchange and interest rate risk and reduce overall cost by using this product. 29.5.1 Note :Branches are very categorically informed that no SWAP structure involving up-front payment of rupees or its equivalent in any form 12
which tantamounts to pre-payment of external commercial borrowings in circumvention of government/rbi guidelines shall be undertaken. 29.5.2 CAPITAL ADEQUACY For reckoning the minimum capital ratio, the computation of risk-weighted assets on account of Long Term Foreign Currency Rupee SWAPS should be done as per the two steps procedure set out below: Step 1: The notional principal amount of each instrument is to be multiplied by the conversion factor given below: Original maturity Less than one year One year and less than two years For each additional year Conversion factor 2.0 per cent 5.0 per cent 3.0 per cent Step 2: The adjusted value thus obtained shall be multiplied by the risk weightage allotted to the relevant counterparty as specified below: Banks/ All India Financial Institutions 20 per cent All others (except Governments) 100 per cent 29.5.3 EXPOSURE LIMITS Branches have to arrive at the credit equivalent amount for the purpose of reckoning exposure to the corporate. For this purpose, the branches should apply the conversion factors to notional principal amounts as per the original exposure method prescribed in 29.E.2 above. The exposure should be within the sub-limit to be fixed for Long Term Foreign Currency Rupee SWAPS within the overall credit limits approved in favour of the corporate 13
as per the credit policy of the Bank and the lending norms prescribed by RBI. Due diligence should be exercised to ensure that corporate undertake Long Term Foreign Currency Rupee SWAPS only for hedging their own balance sheet exposures. A certificate is to be obtained from authorized signatory/signatories of the corporate to the effect that the transactions undertaken by them are meant for hedging balance sheet exposures only ie. The size and tenor of the transactions undertaken are not in excess of their underlying Rupee exposures. 29.5.4 DOCUMENTATION Apart from other documents stipulated by the sanctioning authority and the undertaking required to be obtained as per para 29.E.3 above, branches should obtain ISDA documentation as suitably modified to comply with the guidelines for undertaking Long Term Foreign Currency Rupee SWAPS transactions. Necessary legal advice should be obtained for finalising the ISDA documentation. 29.6. FOREIGN CURRENCY-INR OPTIONS Foreign exchange (FX) options are contracts that give the buyer the right, but not the obligation, to buy or sell one currency against the other, at a predetermined price and on or before a predetermined date. The buyer of a call (put) FX option has the right to buy (sell) a currency against another at a specified rate. If this right can only be exercised on a specific date, the option is said to be European, whereas if the option can be exercised on any date till a specific date, the option is said to be American. Reserve Bank of India vide their AP (Dir Series) Circular No.108 dated 21-06- 2003 have permitted banks to offer Foreign Currency INR Options to residents and non-residents for hedging currency exposures with effect from 07-07-2003 on certain terms and conditions. The few of the main conditions being: 1. Initially, authorised dealers can offer only plain vanilla European options. 2. Customers can purchase call or put options. 14
3. Customers can also enter into packaged products involving cost reduction structures provided the structure does not increase the underlying risk and does not involve customers receiving premium. 4. Writing of options by customers is not permitted. 15