European currency options suited for India: Experts

Foreign exchange experts believe the capital market regulator’s move to allow European options in currency derivatives suits India as the domestic over-the-counter (OTC) market operates using similar option contracts.

Any entity that wants to use currency options as a hedging tool will not have any difficulty in migrating to the exchange platform, which boasts of pricing transparency and nil counterparty risk, they add.

Last week, the Securities and Exchange Board of India (Sebi) gave the go-ahead for launch of premium-styled European call and put options on the exchange platform. Currently, only futures trading is available in the currency derivatives segment of two exchanges, the National Stock Exchange (NSE) and the MCX Stock Exchange (MCX-SX).

The regulator’s decision to prefer the European option over the American option initially came as a surprise. Globally, the latter is more common for exchange-traded options. Even equity stock options on Indian bourses are American in nature.

A European option is one that can be squared off only on the day of expiry (maturity). This is in sharp contrast to an American option, that can be squared off before the expiry date.

Logical step
Experts, however, feel Sebi took the right approach by opting for European options, since market players are already familiar with the broader contours of the instrument.

“India’s OTC currency options market has European contracts, and so, introducing the same on the exchange segment is a logical move by Sebi,” says A V Rajwade, a forex and treasury management consultant. “Anyone who wants to use this for hedging would not have much of a problem migrating to the exchange platform,” adding, “But, it is also true that, broadly speaking, exchange-traded options are American in nature.”

Experts believe some advantages an American option boasts of are more theoretical in nature and, hence, there would not be, in any way, an impact on volumes with the regulator adopting European options.

“While in theory, American options can be exercised any time before maturity, in practical terms, it never is. It is, instead, sold because by selling one can get more than the intrinsic value. The sale price would always be higher. European options cannot be exercised before maturity, but can always be sold before maturity,” explains Rajwade. Intrinsic value is the difference between the exercise price and the market price.

Volume hopes
Another currency trader who did not wish to be named said the exchange-traded currency options segment would see significant volumes, as a lot of day traders and brokers would enter the fray to cash in on the dollar-rupee volatility.

“Options are a favourite of market players, as they have limited downside. The equity derivatives segment is a clear proof of this, where options volume has exceeded that of futures in many of the recent months. Day traders, brokers and corporates would love to speculate in the exchange-traded currency options market. For them, an American or an European contract does not make much of a difference. In practical terms, there are not many significant differences between the two,” he says.

The capital market regulator, meanwhile, has fixed the contract size at $1,000 with three serial monthly contracts, followed by three quarterly contracts of the cycle March/June/September/December. According to a circular issued by the Reserve Bank of India, the maturity of the contracts cannot exceed 12 months. While the premium would be quoted in rupee terms, the outstanding positions would be in dollar terms.

The contract would be settled in cash, in rupees, with the final settlement price being the Reserve Bank Reference Rate on the date of expiry of the contracts. Meanwhile, the expiry/last trading day for the options contract would be two working days prior to the last working day of the expiry month.

The gross open positions of each trading member across all contracts (both futures and options contracts) have been capped at 15 per cent of the total open interest, or $50 million, whichever is higher. For banks, this has been capped at 15 per cent of the total open interest or $100 million, whichever is higher.