Corporates will have to change the way they cut currency derivative deals,
transactions that have rattled India Inc and the government in a way few things have in
recent years. Almost two years after the exotic derivative deals blew up in the face of companies, the rule makers are considering speed breakers which take the fizz out of this market.
The Reserve Bank of India is planning to impose severe restrictions, or even a ban, on “zero-cost deals”, the most popular derivative contracts that corporates have entered into. Hundreds of exporters, importers and firms with expensive rupee loans had struck derivative deals to improve earnings and prune cost.
In the basket of products, zero-cost derivatives turned out to be the hot pick as it allowed companies to get a better exchange rate, far more lucrative than the simple forwards, from banks and sign deals with them at no expense. While the true purpose behind such deals was to hedge the risks that a company faced from fluctuations in foreign exchange rates, the products involved complex packaging and risks that few clients understood.
The regulator feels that zero-cost structures were responsible for much of the losses that companies suffered when their derivative bets backfired. “These structures are under review. Companies went in for these derivatives because they were not required to pay for the cover, and often the losses increased because of the leverage that was built in,” an official said.
The way a zero-cost derivative differs from other contracts is that a company simultaneously buys an option as well as sell another option to the bank; the deal is structured in a manner where the premium earned from selling an option is used to pay for buying the other option, making it zero cost for the company. Consider an exporter who is anticipating a payment of $5 million from an overseas buyer six months later.
In this old-fashioned forward transaction, the exporter has the choice to sell the dollar forward to the bank at 45 a dollar when the present market rate could be, say 43.50. However, if the exporter does a zero-cost deal, the bank offers him a rate as high as 48, something he can’t resist. But here the transaction is more complicated than a simple foward sale of dollar receivable.
In this case, the exporter buys one put option, which gives him the ‘right’ to sell dollar at 48 to the bank; at the same time he sells one call option, under which he is ‘obliged’ to sell the dollar at 48 to the bank. Now, if the dollar is 46 when he receives the payment from abroad, he exercises the put option to sell dollar at 48, thereby earning Rs 2 more than the market rate.
But what happens when the dollar is 50? Here, it makes no sense for the exporter to exercise the put option under which he will receive only Rs 48 a dollar. However, the banks to whom he is obliged to pay (as per the call option) will not ignore the opportunity. They will buy dollar at 48, causing a loss of Rs 2 a dollar to the exporter.
“Without such structures, the market could become more transparent... It would prevent deliberate and complex structuring just to make it zero-cost,” said Phani Shankar, head of treasury at ING Vysya Bank. In real life, zero-cost options are more complex. For instance, an exporter may have sold two or three or even five call options to buy one put option. In trade parlance, these are called 1:2, 1:3 or 1:5 options.
This is where a firm is leveraged and the losses would be higher when the exchange rate moves against the exporter. For instance, in a 1:2 option, the loss to the firm would be Rs 4, and not Rs 2, when dollar is at 50. This is beacuse it has sold two call options. Similarly, the loss would be Rs 6 and Rs 10 per dollar when the greenback is at 50. As the leverage increases — from 1:1 to 1: 3 to even 1:5, the exchange rate offered to the exporter goes up. So, he is tempted to leverage.
According to banking circles, even if RBI does not go for an outright ban, it will restrict the extent to which such leveraging can be offered by banks. “Many firms, particularly SMEs, who are not aware of the risks would benefit. They would concentrate on their businesses rather than making money out of derivatives,” said KN Dey, director, Basix Forex & Financial Solutions. “However, corporates will find ways to get around this,” said Dey who is an advisor to several firms.
According to banking circles, RBI will soon announce the proposed changes in the derivatives rules and ask banks for their views on the matter. There is a distinct possibility that RBI may propose option writing (or selling) by corporates. At present, a corporate can only buy an option, and cannot receive the premium out of selling an option. In several markets only financial institutions are allowed to write options, a transaction where the gain is small but downside could be big.
“Here, the proposal is to allow corporates sell covered options (ie, transactions which are not naked bets but have an underlying like an export or import order). Only big corporates with sophisticated treasuries can take advantage of this. Say, a corporate with a strong view that the dollar will not cross 50 can sell an option and earn a premium. But this can be dangerous if small firms fall for this,” said a senior banker who felt it is unfair to blame zero-cost products since several corporates took a hit after taking pure bets with no underlying.
“The heartburn vis-a-vis derivative losses is attributable to perhaps unwise, but consciously made decisions. Zero-cost structures are popular because they provide value but they are not free lunches,” said Hoshidar Wadia, partner at law firm Juris Corp.
For most corporates, a derivatives market without zero-cost structures could mean a big change. If such products are banned, a corporate can go for a simple forward, or a plain vanilla derivative like buying a put option and paying the premimum prevailing in the market. This can be expensive since option pemium has gone up almost four times in just two years.
Published in Economic Times Dated 27.07.2009
- Why might an offshore investment be superior to an onshore investment?
- The first answer, is, because it is often more lightly regulated, meaning that the behaviour of the offshore investment provider, whether he be a banker, fund manager, trustee or stock-broker, is freer than it could be in a more regulated environment. Any regulator in a high-tax country will immediately say, oh, of course, if it's unregulated, then it is riskier. Well, they would say that, wouldn't they?
