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Hedging the foreign exchange risk

Serious lacuna in cross-currency instruments using futures and options

THE EXTENSION of hedging facilities in the forex markets, announced in the recent credit policy statement, has not evoked the kind of excitement that the Reserve Bank of India's stance on inflation and interest rates has.

Even the related moves in the direction of full convertibility of the rupee hogged headlines leaving the true significance of the enhanced hedging facilities to be appreciated by only those in trade or banks.

Yet the subject is enormously significant and not merely in the context of international trade. India's balance of payments (BOP) depends critically on remittances, services exports (forming part of invisibles) and of course capital flows, both FII and foreign direct investment (FDI). Yet, it is essential that all market participants, including banks and other intermediaries, be provided the wherewithal to undertake forex risk management in a scientific way.

The basic principle for accessing domestic foreign exchange markets is hedging of underlying foreign exchange exposures.

To the facilities traditionally available such as booking of forward contracts, newer ones were added as the domestic forex markets evolved and acquired depth and volumes. Newer hedging instruments have included swaps and options in addition to the foreign exchange forwards.

However, to a very large extent hedging was permitted only against `crystallised' foreign currency exposures. In layman's language it means that only where there is an underlying forex risk arising out of a `genuine' transaction, say an import, will the cover (hedging) be allowed.

Context: topicality

The extension of hedging options will benefit India's trade and has come not a day too soon. On the eve of the latest monetary policy, the exchange rate policy of the RBI was as much in focus as the interest rate policy. There has therefore been a high degree of topicality as well. Obviously, hedging options are particularly relevant at a time of volatile exchange rates .The RBI wants the markets to be better prepared to face volatility and the increased risks.

India's exchange rate policy has ensured that the forex markets remained stable, with the rupee depreciating gradually. The situation changed drastically from March this year when the rupee started appreciating sharply against the dollar. Moving from above 44 to below 41 (to the dollar) in a span of less than two months, the rupee broke several records. There have been several well informed analyses as to why the rupee should become so strong at this juncture and whether such appreciation is in line with the exchange rate policy of the country and so on.

At a practical level, there has been increased awareness of the hedging instruments available as well as a clamour for new ones. Not only is the range of hedging tools being expanded further, but market participants will also be able to hedge on a `dynamic' basis. Two parallel routes are being thrown open. The first are the set of liberalisation measures announced in the credit policy. These include permission given to those in the trade of select metals (aluminium, copper, nickel, lead and zinc) to hedge their price risks in international commodity exchanges. Actual users of aviation turbine fuel are also being given a similar facility to hedge based on their domestic purchases.

Contracts booked by importers and exporters in excess of 75 per cent will have to be on deliverable basis and cannot be cancelled. The earlier limit was 50 per cent. Greater leeway is now being given to resident corporates to hedge their risks arising out of their overseas investments in debt and equity. Procedural changes include the freedom to cancel and rebook forward contracts.

Small and medium enterprises will now be permitted to book forward contracts without underlying exposures or past records of imports and exports.

They are permitted to freely cancel and rebook the contracts. Resident individuals too can book forward contracts without production of underlying documents up to an annual limit of $100,000, which can be freely rebooked and cancelled.

Simultaneously, as Indian markets integrate rapidly with the rest of the world, hedging products offered at international centres such as the Chicago Mercantile Exchange should be harnessed for the benefit of Indian market participants. Cross-currency instruments using futures and options are available but as far as India is concerned there has been a serious lacuna in that none of these instruments is denominated in Indian rupees.

That lacuna is about to be corrected with the Dubai Gold and Commodities Exchange launching the rupee-dollar futures from June this year.

C. R. L. NARASIMHAN

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