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Forex derivative rules to change
June, 30th 2010

The Reserve Bank of India (RBI) is finalising far-reaching changes to foreign exchange derivative guidelines to allow importers and exporters to write and sell put options and earn premium on them. A put option gives its buyer the right but not the obligation to sell a specified amount of an underlying asset at a set price within a specified time.

RBI has also dropped an earlier plan to ban zero-cost structures the most popular derivative product in corporate India. The new norms are expected to be notified soon.

Allowing exporters and importers directly in forex market and the leeway to offer zero-cost structures are moves aimed at expanding the size of the forex derivatives market. The over-the-counter (OTC) forex market has about $13 billion transactions a day. Last year, it used to be about $18 billion. Activity is down this year due to the slowdown in global trade and fall in the balance of payment deficit, said Golaka C Nath, senior vice-president, Clearing Corporation of India.

When financial markets started collapsing in the wake of the Lehman Brothers bankruptcy in September 2008, small and medium enterprises suffered massive losses on their holdings of zero-cost forex structures as their hedges were too low to make up for the market volatility. This led to a demand from several sections to ban the product. An official connected with the exercise said RBI has taken the view that while the scope for excess leverage should be curtailed, the products need not be banned from the OTC market. An OTC market is basically an underlying/hedging/delivery-based market, where participation is allowed only to customers having an underlying foreign currency exposure.

RBI had issued draft guidelines on OTC forex derivatives in November 2009 and final norms were expected by June-end. Many companies sought continuation of the zero-cost derivatives in their inputs to RBI.

In a zero-cost structure, while a client buys a structure after paying a premium, it simultaneously sells a structure to the bank for a premium, thereby nullifying the cost of the derivative,said KN Dey, director, Basix Forex & Financial Solutions.

As per RBI guidelines, a corporate cannot be a net receiver of the premium, but a bank can. A corporate should not enter into a zero-cost structure because these products multiply the risk instead of mitigating them. If a company can pay the premium, it should go for the plain-vanilla option where the maximum loss is the premium paid, Dey said.

Companies buy option contracts to hedge their underlying foreign currency exposure. Like a put option, a call option gives its buyer the right but not the obligation to buy an asset in a similar manner. In a zero-cost structure, the bank sells a call option to the company and the company sells a put option to the bank.

Suppose I want to buy at Rs 40, feeling it will go to Rs 35, I buy a put option at Rs 40 and pay 2 per cent premium. If I dont want to pay this premium, then I buy call options. In case of multiple call options, these are called 1:2, 1:3 call options. This expands the leverage. Because of the built-in leverages in the contracts, there is a problem, explained a forex dealer.

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