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| A V Rajwade: Currency derivatives | | RBI needs to review whether it really wants to depart from limiting the use of derivatives to genuine hedging. |
| A V Rajwade / New Delhi Nov 23, 2009, 00:09 IST |
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 In an article published earlier this month (For that perfect hedge, November 7), I had argued that all plain vanilla currency derivatives should be traded on exchanges to provide price transparency and guaranteed settlements; and that complex derivatives/structured products should be traded over-the-counter only on the basis of full cash collateralisation, on daily mark-to-market basis. Shorty after, RBI came out with draft guidelines on the subject on November 12, which seem to bar all structured products — I must confess that this is an impression as the guidelines merely say that “the facility of zero-cost structures/cost reduction structures is being withdrawn”. Does it mean that complex structured products are fine so long as some fee is recovered upfront, and so long as they satisfy the conditions prescribed in paragraph AII, in particular that the products can be priced locally, and the relevant conditions in the Comprehensive Guidelines issued in April 2007 are met?
One major change is that importers and exporters and, presumably, borrowers of foreign currencies, would be allowed to “write covered call and put options”. What this means is that a company with a payable in foreign currency would be able to write a put option on the foreign currency, and a call on the rupee: The put option gives the right to the bank purchasing the option to deliver the foreign currency to the company, at the strike rate, on maturity of the option. To my mind, this represents a major change in the regulatory philosophy which hitherto had envisaged the use of derivatives only “to hedge an exposure to risk” (the wording is from the notification issued in 2000). The word hedge has not been defined by the RBI; on the other hand, the word “risk” has been defined in the Guidance Note on Market Risk issued in 2002, as “Market risk may be defined as the possibility of loss … caused by changes in the market variables”. The market variables could be interest or exchange rates.
Since the RBI has not defined the word “hedge”, we need to look at other authorities for the definition. Hedge is “a trade designed to reduce risk … goal of a hedging program is to reduce the risk, not to increase expected profits” [“Risk Management in Financial Institutions”(John Hull)], by increasing income or reducing costs. Similar definitions in other standard reference works include the Encyclopedia of Banking and Finance, 10th edition: Hedging is “action taken to reduce risk or market exposure … a form of insurance…It is not speculation, but the avoidance of speculation”.
The key issue in terms of the writing of covered options by companies is whether this constitutes a hedge of any kind. IAS 39/AS 30 specifically argues that “a written option does not qualify as a hedging instrument unless it is designated as an offset to a purchased option” (paragraph A114). To elaborate the cash flows under a covered option, consider that a company with a dollar payable writes a put on the dollar with a strike of, say, Rs 48 and earns Re 1 as fee. If, on maturity, the spot rate is below Rs 48, the option would be exercised and the company would have to buy dollars at Rs 48. On the other hand, if the rate worsens to say Rs 54, the option will not be exercised and the company will need to buy dollars at Rs 54. Clearly, “the possibility of loss … caused by changes in the market variables”, that is, the risk as defined by RBI, has not been hedged. The difference between a delta-hedged option and a “covered” option is that delta can be varied with the changes in the price of the underlying; the “cover” cannot be so changed. Writing options to earn fees is not a business for the amateur.
Another major change is the use of swaps to “transform long term INR borrowing into foreign exchange liability”: the extant regulations allow swaps to be used only for hedging purposes. Transforming the liability currency is nothing but speculative “carry trade”. For example, a company swapping rupee debt for yen (JPY), without any JPY inflows, is clearly doing a speculative trade. [On the other hand, a company with a JPY debt that it swaps into a dollar (USD) or a rupee (INR) is hedging the currency risk either partially or fully.)
A separate issue is the capital charge on the potential future exposure (PFE) on derivatives. The regulatory model takes account of only two variables — whether it is an interest or a currency derivative, and its maturity bucket. The result is that the PFE on a 13-month USD:INR forward contract is the same as on purchase of a five-year USD:JPY option — a patently illogical proposition!
The basic purpose of regulation is to protect the innocent, the unwary and the ignorant. We also need to remember that financial sector reform is not necessarily synonymous with de-regulation and liberalisation: the excessive de-regulation of banking in the Anglo-Saxon world was the root cause of the financial crisis of 2007-08. There clearly is a case for RBI to review whether it really wants to depart from limiting the use of derivatives to genuine hedging.
avrajwade@gmail.com
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