Here we are republishing an article from A First Taste of Law which has now shut down, from old times sake.
India seems to be moving fast towards the introduction of innovative financial products. Readers may recall the detailed discussion on one such product in the form of credit default swaps in the post on The Big Short, where you can read how the use of the instrument played a crucial role in bringing about the crisis. Now the RBI has sought to introduce credit-default swaps (CDSes) and has invited public comments to its draft report on the same. Some of the key features of the RBI proposal on CDSes can be read on the Indian Corporate Law Blog here. Notably, it points out that CDSes will only be permitted to hedge underlying exposure and naked CDSes, which were widely in vogue prior to the financial crisis in the USA, will not be permitted in India. This should check the use of the instrument for speculative purposes.
Regular visitors may also recall our prior post on the Clash of the Titans series, which outlined the framework for trading currency derivatives in India, where we had pointed out that trading in currency futures in four pairs had been permitted, albeit trading in currency options had not then been legalised. RBI and SEBI were working in cooperation to introduce currency options. If you want to know the basics of derivatives and currency derivatives, in general, you can read this paper co-authored by Ramanuj over here.
The SEBI has now introduced trading in currency options on the US dollar – Indian rupee currency pair. The options permitted are of the European style, which implies that the option (whether it is to buy or sell the currency) can be exercised only on the date of expiry, and not at any other time till the date of expiry (this is permitted in case of American options). The minimum size of a single options contract is slated to be USD 1000, a significant sum for a retail investor.
Options contracts may be settled in two ways – physical settlement and a cash settlement. Physical settlement implies delivery of the actual unit of the stock or currency on which the options have been bought or sold. So, if I have a call option to buy a stock at USD 40, which is trading at a given time at USD 50, I can exercise my option on the date of expiry, pay USD 40 and receive the stock. This is a case of physical settlement. Alternately, I could be paid the difference of USD 10 directly, which would be a case of cash settlement. Currency options as per the SEBI Circular are to be cash settled. Details of the SEBI circular may be found here.
Who needs currency derivatives?
International Currency Market is seeing unprecedented volatility. Euro is not reliable anymore in the face of eurozone debt crisis. Recent flight to safety has led to higher prices of USD, but even the United States is going through a very bad economic phase, facing a double-dip recession and has accumulated more debt than it can pay off in decades without substantially damaging price of USD. On the other hand, emerging market currencies are strengthening but are not reliable yet. This is leading to an entrenched sense of insecurity to those having exposure to these major global currencies.
Indian companies providing services in the USA or European countries are perhaps the most vulnerable as average bill collection period has been increasing, and they inevitably run the risk of profit erosion during this waiting period due to change in value of foreign currency. This uncertainty may be very costly as until collection the service provider can not know what is the price that it is receiving in terms of domestic currency, and naturally it will find it difficult to make a price decision. Due to this uncertainty, they are likely to be forced to ask for higher margins, making services costlier than it could have been in the case of certainty of price received.
This kind of problem plagues the exporter and importers of goods to a much lesser extent, as they are in a better position to ask for immediate payment or even insist on payment of a premium for delayed payment, compensating for the risk.
The other category of persons or companies having a significant risk with respect to foreign currency will be those holding assets in foreign countries or in foreign currencies.
Interestingly, it is possible to hedge foreign currency exposure without buying any derivative product by simply taking or giving loans in a currency. For instance, if I am expected to receive USD 1000 in remuneration after a month, I can minimize the risk of currency price fluctuation by taking a USD 1000 loan right now at the current price. This will remove the uncertainties with respect to price of the currency, and the price will essentially be the current price of the currency at the time the loan is taken added up with the interest to be paid on USD 1000 in one month. However, this may be difficult to implement all the time due to the high cost of interest and unavailability of the loan in foreign currency. This is where Currency Derivatives become useful.
Indian economy is one of the few growing economies in the world at this point of time. Given that from investments in foreign currency in India to outbound investments a great many commercial activities can benefit from currency risk hedging, we can say that the time of currency derivatives is coming. The only measure that the regulators have to ensure is that the nascent market should be kept far away from speculation.