HEDGING TOOLS

HEDGING INSTRUMENTS

There are two types of families for Fx Risk hedging in the global financial market and others are combination and permutation of the same. All hedging instruments are attached to these.
 

1. FORWARD FAMILY
    
2. OPTION FAMILY

FORWARD FAMILY is broadly where all the instruments fall under obligatory category and these contractual obligations have to be honoured by the contracting parties.

OPTION FAMILY is like an Insurance product, which can be bought by paying a cost, whereby it can be exercised but without any obligation to do so.

All exposure risk against the Fx Assets and Liabilities can be hedged in several ways. Following are the products allowed by the Reserve Bank of India to hedge currency and interest rate exposure.

PERMITTED HEDGING INSTRUMENTS IN INDIA

1. Hedging Instruments permitted for both Current & Capital Account

   1. Plain Vanilla Forward

   2. Cross-Currency Options

   3. Cost Reduction Structures
       

2. Hedging Instruments permitted for Current Account only

Apart from the hedging instruments mentioned in 1 above, following is the additional instrument allowed for the purpose of hedging of current account transactions –

1. Foreign Curreny-INR Option

3. Hedging Instruments permitted for Capital Account only

Apart from the hedging instruments mentioned in 1 above, following are the additional instruments allowed for the purpose of hedging of Capital Account transactions –

1. Foreign Currency-INR Swap

2. Interest Rate Swap

3. Cross-Currency Swap

4. Coupon Only Swap

5. Interest Rate Cap/Collar (Purchases)

6. Forward Rate Agreement

A brief description of all the above mentioned instruments is given below:

Plain Vanilla Forward – It is a right to buy or sell foreign currency at an agreed Price for a future date. A forward rate is calculated by adding the current exchange rate (called spot rate) of the currency and the forward premium of the forward date. Forward premium is nothing but interest differential between two currencies. Forward premium are freely quoted in the currency market for up to 12 months. All the assets/liabilities can be hedged by way of purchasing/selling a forward contract in OTC (Over the Counter) market. For current account transactions, forward cover can be taken up-to one year whereas for capital account imports it may be booked up-to 3 years subject to the liquidity available in the market.

Note – RBI has also allowed Indian corporates to hedge exchange rate risk transactions denominated in foreign currency but settled in INR, including hedging the economic (currency indexed) exposure of importers in respect of customs duty payable on imports. Such transaction will be settled in cash on maturity and these contracts once cancelled cannot be rebooked. However, in the event of any change in rate(s) of custom duties, due to government notifications subsequent to the date of the forward contracts, importers may be allowed to cancel and / or rebook the contracts before maturity.

Example

An illustration assuming Spot Rate of USD/INR 46.50/01

An importer or an exporter can today fix his price for his future payment obligations depending on the maturity. For example, if an exporter has to receive payment in USD after 3 months, he can take a forward cover for three months today and freeze a rate of 47.07 from the given table. As a result, after three months when the payment comes in USD, his conversion to INR will be on the basis of 47.07 irrespective of whether the USD has moved up or down in these three months. 

Options - Options are unique financial instruments in which the buyer of the option has the RIGHT to buy or sell foreign currency, at a pre-determined price (called the strike rate), for a specified date. However, there is no OBLIGATION for him to do so. The option buyer can simply let his right lapse by not exercising the option. There are two basic types of options – CALL OPTION and PUT OPTION.

There are two categories of Options – PLAIN and EXOTIC. Usually a Plain Vanilla Option is a simple option which may be compared to third-party insurance where the cost of the premium is limited but for the insurance company liability is unlimited. A plain vanilla option as per present ruling is a very simple product where the exit risk and cost is transparent. The risk for the buyer is only limited to the cost of the premium paid without any further future liability. However, the Exotic options are complex products. It is very difficult to assess the risk and the exit cost in view of its proprietary nature. The blatant example is the episode of 2008 when many corporates in India lost heavily due to the lack of transparency about the cost of product and its exit route.

The options contracts are now being traded on exchanges only for USD/INR whereas in OTC options can be traded for any currency. Further, in OTC underline exposure is required as per RBI norms but in the exchange same is not required. This can be used for economic risk hedging without any underlying. Due to its nascent stage, the liquidity is still very thin. When the direction of the currency is not clear, instead of keeping the position open or hedged and incurring a notional opportunity loss/ gain it is advisable to hedge the currency through options. Thus, one can limit the risk to the extent of premium paid and the potential gain could be unlimited.

Globally there are two types of options -

American style options can be exercised at any time up to the option expiry date. This flexibility normally makes the option more expensive i.e. the price paid for the option, the option premium, is higher than for equivalent European options.

European style options can only be exercised on the option expiry date. For this reason they are normally cheaper than the equivalent American option.

RBI only allows European style options in India. So far RBI does not allow selling of naked option. All guidelines applicable for foreign currency-INR foreign exchange contracts are applicable to foreign currency-INR option contracts also.

Cross Currency Options (not involving Rupee) – This hedging instrument is also permitted by RBI to hedge the contingent foreign exchange exposure arising out of submission of a tender bid in foreign exchange. These transactions may be freely booked and/or cancelled subject to verification of the underlying.

Example

CALL OPTION– It gives the option buyer the right to purchase a currency, say US Dollar, against another currency, say Indian Rupee at the strike price on or before a stated date.

PUT OPTION- It gives the option buyer the right to sell a currency, say US Dollar, against another currency, say Indian Rupee at the strike price on or before a stated date.

In any of the above options, the buyer has to pay a cost called “upfront premium” whether he exercises his right or not. Consider an Indian exporter who has to receive a payment after three months and wants to make sure that he does not receive less than INR 47.00 per dollar. In this case, the exporter can buy a PUT option on USD at a strike price of 47.00 paying the upfront premium to the bank as cost. When the actual payment comes after three months and the USD / INR exchange rate moves to 48.00 then the exporter can sell the USD at the ongoing market rate of 48.00 and let the option expire. However, if the exchange rate moves to 46.00 then the exporter can exercise his option and sell his receivables in USD at the strike price of 47.00 as per the contract. Hence, with options one can protect the losses and leave room for unlimited gains. However, pricing of the option (upfront premium) plays an important role in determining its viability. Hence, before taking an option one must be properly informed about the market. Now options are being traded in exchange also besides OTC and hence there is transparency in pricing.

Cost Reduction Structures– As per circular No. A.P (DIR Series) circular No.32, dated December 28, 2010 RBI has allowed various structured products to hedge exchange rate risk arising out of trade transactions and External Commercial Borrowings (ECBs).

Note – Writing of options by the users, on a standalone basis, is not permitted. Users can enter into option strategies of simultaneous buy and sell of plain vanilla European options, provided there is no net receipt of premium. The maturity of the hedge should not exceed the maturity of the underlying transaction and subject to the same the users may choose the tenor of the hedge. In case of trade transactions being the underlying, the tenor of the structure shall not exceed two years.

Currency Swap– Under a currency swap, two counter parties agree to exchange specific amounts of two different currencies, at the outset, and repay these over time in installments, reflecting interest and principal. It is nothing but a combination of forward contracts for longer maturity. While plain vanilla forward is confined up-to one year, the currency swap is being taken for any maturity beyond one year.

Interest Rate Swaps (IRS)- An agreement between two parties (known as counter parties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

Example

Company A is currently paying floating rate of interest on its USD loan, but wants to pay fixed. On the other hand Company B is currently paying fixed rate of interest but wants to pay floating. By entering into an interest rate swap, each party can 'swap' their existing obligation for their desired obligation. In this case B makes periodic interest payments to A based on a variable interest rate of LIBOR +70 basis points. Company A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. Normally the parties do not swap payments directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments. 

   

By doing the IRS, company A has now got fixed rate funds at an effective cost of 9.60% ( it pays 8.65% to B and also has to pay differential 0.95% i.e 1.50% - 0.55% over Libor). On the other hand company B has now floating rate of funds at Libor + 0.70%.

Coupon only Swaps- It is similar to IRS, where the rates are determined by the participants themselves. This could be a cost-reduction strategy and same is being allowed by RBI.

Principal Only Swap– It is like currency swap only. However, in currency swap both principal and interest are being exchanged between the parties. In POS only principals are exchanged on pre-decided maturities.

Purpose of Foreign currency-INR swap is to hedge exchange rate and/or interest rate risk exposure for those having long-term foreign currency borrowing or to transform long-term INR borrowing into foreign currency liability.

Note– As per RBI guidelines, the swap transactions, once cancelled, shall not be rebooked or re-entered, by whichever mechanism. The notional principal amount of the swap should not exceed the outstanding amount of underlying loan. The maturity of the swap should not exceed the remaining maturity of the underlying loan.

Example

An Indian company ABC Ltd. whose cash flows are in Dollars has taken a loan in Japanese Yen to finance some capital goods imports. Now the company is exposed to the fluctuation in USD/JPY exchange rate. To eliminate this risk, company would want to assume a dollar liability since it has cash flows in dollars. Currency Swap can facilitate this. Let’s assume that the Yen loan is repayable in 10 equal half- yearly instalments of JPY 100 million each and the prevailing spot rate of USD/JPY is 100 yen to a dollar. The swap would involve receiving Yen 100 million and paying out USD 1 million every six months for next 5 years.

For the principal payments alone cash flow exchange every six months would be –
 

                                                                                                                                              USD 1 Million
                               LENDER                                                               ABC LTD.   ------------------------------------------------->   BANK
                                             <---------------------------------------------------                       <-------------------------------------------------
                                                                   JPY 100 Million                                                       JPY 100 Million

Forward Rate Agreement (FRA)– This is an agreement between two parties, typically a bank on one hand and borrower/depositor on the other hand, the former guaranteeing the latter, a fixed rate, on an agreed future date. This instrument is used to freeze/defreeze interest payments from fixed to floating or vice versa on the basis of LIBOR which can be fixed in advance. Thus one can mitigate the LIBOR risk by freezing the future LIBOR rates today by adding some cost in case a view is taken for rising Libor or vice-versa. 

This is a similar product like Forward contracts. The IRS explained above is a combination of series of dates of FRA.

RBI allows use of IRS, Cross-currency swap, Coupon Swap, Cross currency option, FRA, Interest Rate cap or collar (purchases) to hedge borrowings in foreign exchange, which are in accordance with the provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000. This allows hedging of interest rate risk and currency risk on loan exposure and unwinding from such hedges. However, none of the products should involve rupee under any circumstances. The notional principal amount of the product should not exceed the outstanding amount of the foreign currency loan. The maturity of the product should not exceed the unexpired maturity of the underlying loan. The contracts may be cancelled and rebooked freely.

Within the guidelines, terms and conditions specified, RBI also allows hedging currency risk of probable exposures on the basis of declaration based on past performance up to the average of the previous three financial years. However, this facility is extended only in respect of trades in merchandise goods as well as services. Products allowed for the same are – Forward foreign exchange contracts, cross currency options (not involving Rupee), foreign currency-INR options and cost reduction structures.

Example

Suppose the current month is February. Company ABC needs $5,000,000 in April which it can repay back in May. In order to hedge against the risk that interest rates may be higher in April than it is in February, the company enters into an FRA with Bank Z at 6% FRA rate. In this case it would be a 2X3 FRA, meaning a 1 month loan to begin in 2 months, with a notional principal of $5,000,000. In April, if the interest rate rises to 8%, Bank Z would pay company ABC the increased interest arising from the higher rate i.e 2%. If on the other hand interest rate falls to 5%, company ABC would pay Bank Z the differential 1%.

Settlement of FRA -

·         No exchange of principal.

·         Only interest differential on notional amount is exchanged.

FRAs trade over the counter (OTC), and because they are not exchange traded, both the notional amount of the loan and the FRA rate can be negotiated and customized. Also, since the contract is cash settled, no loan is actually given or received, but rather the contracts are settled on the first day of the underlying loan.

FRAs are quoted in the format AxB, with (A) representing the number of months until the loan is set to begin, and (B) representing the number of months until the loan ends.

Futures- Futures is also a part of the FORWARD FAMILY. Future trading was introduced in India two years back after commitment by our Prime Minister in G20 meet for trading in USD, EURO, GBP and JPY against INR. A futures contract is similar to the forward contract but it is traded in an organized exchange unlike the forward contracts which are traded only in OTC. The main advantage of futures is that it does not require any underlying exposure unlike forward contract. Moreover, there are certain fundamental difference like size of contract, maturity (tenure) all are fixed. However, it could be a good product to hedge economic risk if the company desires so.

There is no fixed formula for the applicability of these products and every product has to be evaluated on the basis of merit and demerit and its requirement to the company.