Banks Can Use Derivatives To Hedge Portfolio Risks
The Reserve Bank of India has allowed authorised dealers to use derivatives to hedge risks on their own portfolio, thereby implementing the recommendations of the Sodhani committee on the foreign exchange market.
Interestingly, the apex bank has allowed banks a little bit of leeway which will enable genuine hedge position to turn speculative. Earlier, banks could sell derivatives to corporates to hedge exposures but could not cover their own risks.
Ever since the burden of covering the exchange risk on FCNR deposits was shifted to banks in 1993, the banks had been demanding that they should be allowed to use derivative products to manage their foreign currency assets and liabilities. Since this was also endorsed by the Sodhani committee, the RBI has permitted use of interest rate swaps, currency swaps and forward rate agreements to hedge their asset-liability portfolio.
In an interest rate swap, a bank can move from a floating interest rate to a fixed interest rate or vice versa depending on the view it takes on the movement of interest rates. For instance, if the bank has a floating rate liability, and it feels that interest rates are expected to move up, it can shift to a fixed interest rate. On the asset side, banks could shift to floating rate from fixed if the rates are likely to move up.
In a currency swap, a bank, for instance, can swap a dollar liability with a yen liability if its corresponding assets are in yen.
The currency swap also covers interest rate risks. For instance, the dollar interest rates can move up which increase the cost of the banks liability and the yen interest rates can move down reducing the income of the bank. The currency swap will hedge this risk too.
A forward rate agreement, which banks can now issue, essentially locks the buyer of the derivative to a rate of interest at a future date. For instance, if there is a repayment in dollars and the interest rates are expected to move up, the bank at day one lock into an interest rate for a transaction six months down the line.
The RBI has asked banks to have an "appropriate risk management policy envisaging the use the above instruments". It has also stated that the value of the hedge should not exceed the value of the underlying amount and the maturity of the hedge should not exceed the maturity of the underlying. In other words stand-alone transactions should not be initiated, the RBI has warned.
By barring stand-alone transactions, the RBI has prevented speculation, but then it has also given certain relaxations. "However, in the event of a hedge turning naked either in full or in part owning to the shrinking of a portfolio and other changes in composition, such transactions may be allowed to continue till maturity," the RBI said.
This means that if the underlying deposit which has been hedged is prematurely withdrawn the derivative need not be cancelled. Hence, after the underlying deposit is withdrawn, banks can make a profit on the derivative.
The RBI has said that the net cash flows arising out of these transactions should be booked as income and expenditure and would form part of the exchange position. While the outstanding items need not be subjected to revaluation, those that are not backed by an underlying asset or liability should be marked to market at regular intervals.
Authorised dealers should report details of the transactions put through on a quarterly basis.