Treasury Management

Forex and Treasury Management
i
The Institute of Chartered Accountants of India
(Set up by an Act of Parliament)
New Delhi
Forex and Treasury
Management
ii
Reprint Edition : August 2012
Edition : January, 2012
Board/ : Committee on Financial Markets and Investors Protection
Committee
Website : www.icai.org
E-mail : cfmip@icai.org
Price : ` 400/-
ISBN : 978-81-8441-503-2
Designed and : Finesse Graphics & Prints Pvt. Ltd.
Printed by Lower Parel, Mumbai 400 013.
January, 2012/ 500 Copies
iii
S. No. Particulars Page no.
1. Introduction to Global Markets and Treasury Management ................... 1
I. Evolution of Foreign exchange market ........................................................1
An Overview .................................................................................................1
Global Financial System ................................................................................2
Important developments during this period include: ...................................5
II. Treasury Management ...................................................................................7
Scope and Functions of Treasury..................................................................7
The scope of Treasury activity would cover ................................................8
Treasury Organisation .................................................................................11
Integrated Treasury .....................................................................................12
III. Globalisation ................................................................................................13
2 Concepts behind Foreign Exchange Arithmetic ..................................... 16
Forward Quotes ..................................................................................................17
Cancellation of forward contracts ......................................................................19
Some illustrations for forward rate calculation...................................................21
3. Foreign Exchange Risk Management ........................................................23
I. Foreign Exchange Risk ................................................................................23
Foreign exchange risk is part of market risk .............................................23
Foreign exchange risk is a cashflow risk ....................................................24
Foreign exchange gains/losses are to be viewed in a specific context .....25
Transaction Risk ..........................................................................................26
Translation Risk ...........................................................................................26
Economic Risk .............................................................................................27
II. Risk Management ........................................................................................27
A. Exposure Identification ......................................................................28
B. Target Rate .........................................................................................29
Contents
iv
C. Hedging Strategy ................................................................................31
D. Hedging Instruments ..........................................................................32
E. Risk Monitoring ..................................................................................33
III. Regulatory Environment .............................................................................36
Annexure-1 Impact of central banks intervention ..........................................40
4. Derivatives - 1 ........................................................................................... 41
Introduction to Derivatives .................................................................................41
OTC and Exchange Traded Derivatives ..............................................................43
Currency Swap ....................................................................................................50
Operationally the three variants of currency swap function as under: .............50
Interest Rate Swaps (IRS) ....................................................................................51
Exchange Traded Derivatives: Currency and Interest Rate Futures ..................52
5. Derivatives 2 .......................................................................................... 53
Option Pricing......................................................................................................53
Use of options .....................................................................................................54
Combination of options.......................................................................................55
1) FX Range Forward .............................................................................56
2) Participating Forward Option ............................................................56
3) Put/Call Spread...................................................................................57
4) Seagull Structures ...............................................................................57
Exotic Options .....................................................................................................59
Interest Rate Swaps (IRS) ....................................................................................60
Pricing & Valuation of Swaps ...............................................................................62
Interest Rate Derivatives: Option Products ........................................................65
Use of derivatives in Risk Management ..............................................................66
Use of Forward Contracts ..................................................................................67
Use of Option Products ......................................................................................68
Use of Interest Rate Swaps and Options............................................................71
Annexure 1 Black & Scholes (GNK) Option Pricing ........................................73
v
Annexure 2 Currency Swap (P+I) Calculation ...............................................75
Annexure 3 Commonly Used Greeks in Options ...........................................76
6. Developments in Indian Market .............................................................. 77
Regulatory Environment ......................................................................................77
Use of Derivatives ...............................................................................................77
Comprehensive Guidelines on Foreign Exchange Derivatives ...........................78
Market Makers ....................................................................................................78
Type of Options ...................................................................................................78
Underlying Exposure ...........................................................................................79
Probable Exposure ..............................................................................................79
FIIs ....................................................................................................................79
FDI ....................................................................................................................79
Cost Reduction Structures ..................................................................................79
Swaps ...................................................................................................................80
Suitability & Appropriateness ..............................................................................80
Corporate Governance .......................................................................................80
Hedging Commodity Price Risk and Freight Risk ...............................................81
External Commercial Borrowings .......................................................................81
Foreign Direct Investment (FDI) .........................................................................83
Portfolio Investment Scheme ..............................................................................86
Investment in Debt Market .................................................................................86
Overseas Direct Investment (ODI).....................................................................86
Liberalised Remittances Scheme (LRS) ...............................................................87
Other RBI Regulations .........................................................................................88
Developments in Indian Markets ........................................................................88
Supplement: Exchange Traded Products Currency Futures, Options
and Interest Rate Futures ....................................................................................91
Contract Terms: Currency Futures .....................................................................94
Contract Terms: USD/INR Options ....................................................................96
vi
7 Managing Bank Treasury .......................................................................... 98
Organisational controls ........................................................................................99
Internal Controls ...............................................................................................100
Exposure Ceiling Limits .....................................................................................103
Market Risk ........................................................................................................104
Risk Measures: VaR and Duration .....................................................................104
1. Value at Risk (VaR) ...........................................................................105
2. Duration ...........................................................................................106
Use of Derivatives in Treasury ..........................................................................109
Annexure 1 .....................................................................................................110
8 Asset-Liability Management ................................................................... 114
Managing Liquidity .............................................................................................115
Measuring liquidity mismatches .........................................................................117
Interest Rate Risk ..............................................................................................118
Measuring the interest rate sensitivity (IRS) gap ..............................................119
Interest Rate Risk Management ........................................................................120
Currency Mismatches ........................................................................................121
Crisis Management ............................................................................................121
ALM set-up in banks .........................................................................................122
Role of Treasury in ALM ...................................................................................122
Credit Risk and Credit Derivatives ...................................................................124
Treasury and Credit Risk ...................................................................................124
Credit Derivatives Credit Default Swaps (CDS) ...........................................124
Transfer Pricing ..................................................................................................126
Policy Environment ............................................................................................127
Annexure 1 Credit Default Swaps in India ....................................................128
9 Global Financial Markets ........................................................................ 132
Resource Mobilisation in global markets ..........................................................133
Cost considerations ...........................................................................................134
Currency matching ............................................................................................134
vii
Diversification ....................................................................................................134
Risk Management ...............................................................................................134
Equity Issues ......................................................................................................134
Indian Depository Receipts (IDR) .....................................................................136
Debt Issues ........................................................................................................136
Mobilising FC funds ...........................................................................................137
Syndicated loans ................................................................................................138
Issue of debt paper ...........................................................................................139
Issue of USD debt in Global or US Domestic Markets ...................................139
Coupon bearing bonds ......................................................................................139
Exchangeable Notes/bonds ...............................................................................139
Medium Term Notes .........................................................................................140
Optionality .........................................................................................................140
Convertibility Option.........................................................................................140
Perpetual Bonds .................................................................................................141
Asset-based securities .......................................................................................141
Junk bonds .........................................................................................................142
10 Trade Finance .......................................................................................... 145
Indias Foreign Trade .........................................................................................146
Trade Finance .....................................................................................................146
Letter of Credit .................................................................................................147
Export Credit ....................................................................................................150
Import Credit ....................................................................................................150
General ..............................................................................................................151
Exchange Rate Risk Management ......................................................................152
Abbreviations ....................................................................................................152
Annexure 1 INCO Terms Commercial payment terms
used in international trade, as approved by International
Chamber of Commerce (ICC) ..........................................................................153
Foreign Exchange & Treasury Risk Management .......................................... 159
Reference Books ................................................................................................159
viii
1
Introduction to Global Markets and
Treasury Management
I. Evolution of Foreign exchange market
An Overview
Foreign exchange (forex) market has steadily grown in size and
complexity over the last 10 years. The latest tri-annual survey of Bank for
International Settlements (BIS) pegs the daily average turnover of global foreign
exchange markets at USD 3.981 trillion, based on Apr 2010 data. The turnover
has more than tripled from 2001 levels - a CAGR of 12% p.a., which compares
with average world GDP growth rate of 3.76% during the same period.
Foreign exchange transactions originate from
Export-import trade
Capital flows
Personal remittances, and
Speculative deals
Purchase and sale of currencies also take place on account of hedging
activity, where currency risk arising out of trade and capital flows is hedged
using derivatives like forwards, swaps and options.
The volume of exim trade flows and aggregate capital flows amounted
to USD 23 trn and USD 1.2 trn respectively for the entire year of 2010. Even
after allowing for an equal volume of hedging instruments, it is obvious that a
large part of daily average forex turn over of USD 3.91 trn is accounted by
speculative deals, also referred to as currency trading. Personal remittances
account only for a small part of forex turnover.
The composition of forex activity reveals that spot trades constitute only
38% of the volume, balance accounted by forwards, swaps and options. USD
continues to be the dominant currency, accounting for almost 85% of the global
forex transactions. As a currency pair, Euro/USD accounts for 30% of the forex
volume. Other major currencies in order of importance are JPY, GBP and CHF.
1
CHAPTER
2
The above data pertains only to over-the-counter products, i e foreign
exchange transactions where one of the counterparties is always a bank or a
financial institution. There is a corresponding exchange traded products market,
where currency futures and options are traded with the futures exchange (or
stock exchange covering futures) as the counterparty. However, the futures
turnover is only a fraction of OTC turnover, amounting to a daily average of
USD 168 bn, or about 4% of the OTC turnover.
A corollary to the currency derivatives is interest rate derivatives, where
interest rate swaps and interest rate options are traded both in OTC as well
as futures exchanges. Interest rate derivatives may not always involve currency
conversion, though as hedging instruments, they are most popular for converting
interest rate on foreign currency assets and liabilities into interest rate payable /
receivable in domestic currency. Unlike in currency markets, turnover of exchange
traded interest rate derivatives (daily average USD 8.142 bn) is much higher than
that of the OTC products (daily average USD 2.057 bn).
Foreign exchange market, unless otherwise mentioned, refers to OTC
market which is the most liquid market, with currency trades taking place
across the time zones 24 hours-a-day, and with live market information
accessible on line to all market participants irrespective of their location. While
the currency market is universal, in terms of deal negotiations and settlements
taking place, most important money centres are London, New York, Frankfurt,
Tokyo, Hong Kong, Singapore and Sydney. Emerging markets like Shanghai,
Mumbai and Dubai are also fast growing in their importance.
The institutional participants in foreign exchange market other than
commercial banks include investment banks, insurance companies, mutual
funds, hedge funds and pension funds. The banks and financial institutions
mostly extend intermediary services such as forex dealing, brokering and
portfolio management, though at times, they may also use the products for
their own requirement (e.g. expansion in to foreign markets). The end users
are exporters and importers, corporates with overseas operations, currency
traders, governments and individuals. Increasingly large corporates have part
of their debt or equity denominated in foreign currency, with exchange rate
movements having a significant impact on their balancesheet.
Global Financial System
The evolution of global financial system is closely linked to paper money
replacing metals mainly gold and silver as a medium of exchange in the
3
early 18th century. United Kingdom was the first country to formally adopt gold
standard in 1821, while Germany and rest of Europe switched from silver to
gold standard only in 1870s. The US passed Gold Standard Act in 1900, finally
putting a stop to their bi-metallic system of gold and silver. Thus by end of 19th
century more than 50 major countries (with the exception of China with silver
and many regional currencies in circulation) adopted a uniform gold standard
for international trade.
Gold standard meant that the currency issued by the central bank of a
country is fully convertible into gold at a fixed price and exchange rates were
determined with gold price as the benchmark. Incidentally, East India Trading
Company, whose business was later acquired by British Government, was a
major contributor to global trade, which increasingly required cross border
payments for goods and services.
The problem with gold standard was that physical gold was to be
shipped often to settle balance of payments between central banks. With the
outbreak of World War I in 1914, gold shipments were hampered and several
countries, including US, UK and Germany withdrew the gold convertibility
and stopped gold payments. Though all the major currencies returned to
gold standard by 1928, the system could not survive the Great Depression
of US in 1929 which affected all the trans-Atlantic countries resulting in
collapse of world trade. Liquidity problems led to devaluation of currencies
and hyperinflation in Europe. The breakdown of global financial system was
complete by the on-set of Second World War in 1935.
The global financial system formally came into existence with the
establishment of Industrial Bank for Reconstruction and Development (World
Bank), International Monetary Fund (IMF) and World Trade Organisation
(WTO)* following the Bretton Woods Agreement in 1944. The countries that
took part in Bretton Woods agreement discard the gold standard and agreed
to fix exchange rates with USD as the benchmark. USD was fully backed by
gold reserves valued at fixed price of USD 35 per troy ounce. The maximum
variation in currency exchange rate was limited to 1% on either side beyond
which the IMF would intervene and advise measures required for rebalancing
the currencies. In order to avoid competitive devaluations, maximum
devaluation of a currency was restricted to 10%.
* Originally General Agreement on Trade & Tariffs (GATT) replaced by WTO in 1995
4
Bretton Woods system initially led to stable exchange rates, with USD
as reserve currency. USD was supported by the guarantee of US Government
to convert USD into equivalent gold at a fixed rate, on demand. The other
support for the system was IMF who would step in whenever a country faced
serious balance of payment (BOP) problems, necessitating devaluation or re-
setting of the fixed rate of exchange. The system however, got disrupted over
the next three decades owing to two factors: a) speculators started betting
on currencies in anticipation of devaluation / re-set of exchange rates, and b)
countries in surplus were accumulating USD reserves, instead of revaluing their
currencies. As a result, US had to absorb huge deficits and still had to maintain
enough gold reserves to back excess supply of dollars. US also had to incur
excessive expenditure in Vietnam War, which added to its deficit. At the same
time US was reluctant to devalue the dollar.
Persistent deficits eroded confidence in USD and soon a stage was
reached when the US could no longer afford to exchange the dollar for gold
at the committed rate. On 15 August 1971, US unilaterally removed the gold
backing and no longer there was a commitment to exchange gold at a fixed
rate. Group of Ten countries entered in to an agreement in December 1971
which came to be known as Smithsonian Agreement - to devalue USD and
refix the gold conversion rate at USD 38 per ounce.
In 1972, in order to counter the importance of US Dollar, European
Economic Community of six nations, agreed on a exchange rate system a
join float known as snake - within the community allowing for movement of
exchange rates within a limited pre-fixed band.
Eventually the joint float of EEC as well as the Smithsonian Agreement
failed to regulate the exchange rates, giving place to a free float of exchange
rate, which continues to date.
In the absence of a universal agreement, free float allowed countries
either to
a) float the currencies to discover market determined exchange rates, which
constantly change based on demand for and supply of a currency (which
in turn derive from exim trade, capital flows and speculative trading), or
b) manage the exchange rate of the currency within a pre-fixed band, often
necessitating devaluation or revaluation of currencies, or
c) peg the currency exchange rate to a major currency, with a semblance of
stability achieved from the fixed exchange rate against, say, USD or GBP.
5
All major currencies, including USD, Deutsche Mark, French Franc, GBP
and JPY embraced floating rate system in the 1980s and came to be known as
free currencies as they had to do away with exchange rate regulations. Hong
Kong, Argentina and some of the Middle East countries opted for a pegged
rate against USD or GBP. Most of the countries in the developing world (or
Third World as known at that time) enforced an official exchange rate under a
managed system, which necessitated strict exchange controls and protectionist
trade policies.
The 80s and 90s witnessed higher volatility of currencies, change in
exchange rate regimes, innovation in financial markets, globalization of trade
and market intervention by central banks in varying degrees. Even in free
market countries, central banks had an increasingly important role to control
high inflation: US suffered high inflation with low growth in the 70s and 80s
which necessitated tough monetary policy measures from Federal Reserve,
while Japan, after an exceptionally high growth in 80s went in to deep
recession in the 90s partly accentuated by a volatile currency. The world
economy despite a relatively high overall growth rate, limped from one crisis
to another, ranging from a savings & loan crisis in US in late 80s, to hyper
inflation and sovereign defaults in Latin America, Russian default and Mexican
and Asian market crises in 90s. The last one in particular, led to a review of
capital controls in emerging market countries and a general rejection of IMF-led
market reforms.
Exchange rate regimes across the countries have also undergone
significant changes. The perceptible change in exchange rate regime took
place after the crisis in East Asian financial markets in late 1990s, which was
preceded by crisis in Latin American countries mainly in Mexico and Argentina.
The distinction between free float and managed float is getting eroded as most
of the developing countries have made their currencies partly convertible and
even the countries with free float are retaining some control on capital flows.
The pegged currencies have almost disappeared in technical sense save for
Hong Kong dollar, which continue to be pegged to USD. Some of the Middle
East countries maintain a loose peg with USD. However the fixed rate regime
of China at one end and the free float currency of Singapore on the other end
are both loosely pegged to USD in varying degrees, and the movement of their
currencies is indirectly synchronized with USD.
Important developments during this period include:
Emergence of Euro as a single currency for European Union an expanded
form of EEC now embracing 27 countries, which fully replaced individual
6
European currencies (except for UK, a member country and a few other
countries like Switzerland and Sweden who have not joined Euro) by the
end of last century
Invention of electronic money increase in money supply with the use of
credit cards, debit cards and on-line settlements superseding paper money,
and
Financial innovation with new products like currency and interest rate
derivatives and combinations thereof, credit derivatives like credit default
swaps and asset based securities providing scope for high leveraging and
synthetic money
The first decade of 21st century witnessed proliferation of exotic financial
instruments, finally resulting in a global debt market crisis triggered by US
sub-prime mortgage crisis in 2007, but fast enveloping the entire financial
markets. The turbulence in global markets affected major banks and other
financial institutions, leading to extinction of some and restructuring of some
others, mainly in US and Europe, with an overhaul of central banks regulations.
The latest crisis, in a way continuation of the earlier one, to hit global
financial markets is the sovereign debt default or probability thereof, in some of
the EU member countries, which is still evading a lasting solution. The survival
of Euro as a single currency is being questioned in some quarters. On the other
hand, US perhaps more for political than economic reasons losing its AAA
status at least with one rating agency, casts fresh doubts on stability of USD as
a reserve currency.
At the same time, WTO induced trade reforms led to much lower tariffs
and globalization of trade. Emerging Market Countries witnessed impressive
growth rates coupled with financial reforms, China becoming a dominating force
in commodity markets. Environmental considerations are driving research in to
low cost renewable energy. Cross-border capital flows are much freer and in
some instances, have become more important than trade flows in determining
exchange rate trends.
Despite phenomenal changes in world economy, and in financial markets
in particular, it is interesting to see that debate amongst economists is refocused
on factors like excessive debt, speculative prices (in equity and real estate),
excess capacity (low consumption rates) and unemployment the very same
factors which reportedly caused the Great Depression in 1929 when the global
financial system did not exist.
(Please refer IMF website for further information on currency regimes)
7
II. Treasury Management
Scope and Functions of Treasury
Conventionally, the Treasury function was confined to funds management
maintaining adequate cash balances to meet day-to-day requirements,
deploying surplus funds generated in the operations, and sourcing funds to
bridge occasional gaps in cash flow.
In the context of a bank, the Treasury is also responsible to meet
reserve requirements, viz. holding with Reserve Bank of India minimum cash
balances required as per Cash Reserve Ratio (CRR), and investing funds in
approved securities to the extent required under Statutory Liquidity Ratio
(SLR). Thus, Treasury function was essentially liquidity management, and from
an organizational point of view, Treasury was considered as a service centre.
To date, liquidity management continues to be an important function of
Treasury. However, owing to economic reforms and deregulation of markets
over the last two decades, the scope of Treasury has expanded considerably.
Today liquidity management or cash management implies managing cashflows
denominated in different currencies with attendant risks and constraints.
Currency mismatches give rise to foreign exchange risk, while maturity
mismatches generate interest rate risk. Cash surpluses may be invested in
domestic or global markets, short or long-term instruments, in debt or equity
markets depending on the regulatory and policy guidelines. Similarly funds for
bridging cashflow gaps can be sourced from different markets, using different
instruments. Modern Treasury thus envelops foreign exchange, investment
banking and risk management areas in a global context.
Treasury has since evolved as a profit centre, with its own trading
and investment activity. Treasury connects core activity of a company
(manufacturing/ trading / services) or a bank (deposit taking and lending)
with the financial markets by continuously accessing the markets for currency
exchange, resource management and trading in financial assets. And owing to
its interface with markets, managing market risk for the company or bank has
become an integral part of Treasury.
Treasury may thus be defined as a bridge between product markets
and financial markets, dealing with products in financial markets in order to
meet business requirements on one hand and to exploit market opportunities
and optimize profits on the other hand. Treasury covers the area of foreign
8
exchange, money market, debt and equity markets, including hybrids like repos
and convertible securities. Treasury uses derivative instruments to manage the
risks across the market segments.
The scope of Treasury activity would cover
Purchase and sale of currencies to meet business requirement (trade and
investment)
Trading in currencies and securities, as permitted by regulations and within
the limits set by the Board
Short-term borrowing and lending using instruments like CP, CD, Repo,
and corporate debt paper
Swapping foreign currency and Rupee funds for interest arbitrage or for
funding needs
Investment in tradable stock
Managing foreign exchange risks using currency and interest rate
derivatives
Managing domestic exposures using Rupee derivatives
Roll over/cancellation of hedge contracts in response to market
movements
Settlement of foreign exchange, money market and derivative deals on due
date
Accounting for all treasury deals, including mark-to-mark (MTM) valuation
of liquid market instruments and derivatives
While the scope of activity is essentially same, a bank treasury differs
from corporate treasury in some of the functional areas that include the
following features in the Indian context:
Bank Treasury Corporate Treasury
Bank is a financial intermediary, hence
primary objective of bank treasury
is to cater to the requirement of
customers who need to buy or sell
foreign exchange
Corporate Treasury is the end-user:
will deal in foreign exchange only to
meet its business requirements
9
Bank Treasury Corporate Treasury
Only banks as authorized dealers can
buy or sell forex from customers as
well as from banks and other entities
in domestic and global markets
Corporate Treasury can deal in foreign
exchange only with AD banks can
not buy or sell forex from other
entities even if they have surplus FC
funds
Banks are authorized to trade in
currencies maintain positions to
take advantage of market movements
within approved limits
Corporates are not permitted to
trade in foreign exchange, except in
futures market with Rupee settlement
Bank Treasury is required to maintain
minimum liquidity level and also
meet CRR and SLR requirements as
prescribed
Liquidity is important for Corporate
Treasury, but there is no statutory
requirement to maintain a minimum
level
Bank Treasury is closely involved in
Asset-Liability Management and is
expected to contain the interest rate
mismatches within tolerance levels
Corporate Treasury is more focused
on hedging its revenue exposures
and liability management, i.e. hedging
currency and interest rate risks of FC
loans
A bank is permitted to be market
maker in derivatives, hence Bank
Treasury can engage in derivative
trades (subject to permission from
RBI)
Corporate Treasury cannot trade in
derivatives
Investment in debt securities is closely
linked to core business of the bank
and there is no constraint on funds
that can be deployed in investment
business
Corporate Treasury can invest only
surplus funds in investments, unless
the company is in investment business
Classification of banks investment in
to HTM, held for trading etc. should
strictly conform to the norms laid
down by RBI
Classification of corporate investments
need only to comply with the
accounting standards
10
Despite the differences, treasuries of large corporates in India function
similar to bank treasuries and are able to impact markets with their timely
response to market developments. Globally some of the large corporate
treasuries (e.g. General Electric) are indeed larger than several bank treasuries.
Corporate Treasury assumes the role of a profit centre by exploiting
market opportunities, as also by efficient conduct of treasury activity. Following
are some of the ways Treasury can add to business profits in forex area:
Based on volumes, Treasury negotiates finer margins with the bank in a
way that the bank quotes for purchase/sale of currencies is nearest to
market quote.
Treasury decides on most appropriate hedging instruments, using forwards
or combination of options in order to minimize the hedging cost within
the approved risk limits.
Treasury tracks mark-to-market value of hedges (e.g. forward contracts)
and in favourable market conditions may cancel the contract and lock into
the profit, subject to regulatory provisions. Treasury should of course keep
track of MTM value of underlying exposures also and ensure that pre-set
stop-loss limits if any, are not exceeded.
Treasury would immunize the FC loan portfolio from market risk, by
hedging currency and interest rate risks intelligently, so as to protect initial
advantage over domestic borrowing. In adverse market conditions, using
hedge instruments like plain vanilla options or call spreads, Treasury may
even be able to bring down effective cost of borrowing.
Treasury would always be looking for arbitrage opportunities to swap FC
funds in to Rupee or use buyers credit or PCFC in lieu of Rupee funding
in order to benefit from interest rate differentials of the two currencies.
Treasury can also engage in currency trading without any restrictions in
currency futures market, provided the management has in place a risk
management policy with necessary risk limits.
Of course, all the operations described above presuppose appropriate
skill sets for treasury staff, as also a well developed foreign exchange and
derivatives market in a healthy regulatory environment the latter conditions
are abundantly present in India.
11
Treasury Organisation
Treasury needs to have a dedicated staff contingent as distinct from
finance, as Treasury is the companys interface with the financial markets.
Treasury activity is to be segregated into front Office and Back Office.
The Front Office will be responsible for dealing with the market. Within
the Policy guidelines, the Front Office will buy/sell currencies, enter into hedging
deals, maintain positions and observe the stop-loss and exposure limits. The
front Office is the dealing room where the dealers negotiate and conclude forex
deals with counter party banks (as also large corporate clients). The Dealers
may also take a view of the market and decide to hold their positions/trade
exposures of the company, open or hedged, fully or partially (subject to any
policy constraints).
Back Office will be responsible for confirmation of the deals, accounting
for the deals, cashflow management and reporting under the MIS. Back Office
will check confirmations received from the counter-parties (banks) on the basis
of deal slips and will ensure that the settlement is carried out promptly. Back
Office will also be responsible for compliance with the Risk Limits and Exposure
Limits and will report any exceptions to the Management.
It is necessary that Front Office and Back Office functions are segregated
separately, so that the Back Office will function as a check on the dealing room
operations. To ensure the independence, Back Office should report to a head
other than chief dealer or immediate head of forex, even if both the heads are
reporting to Head Treasury or CFO at senior management level.
For banks and large corporate treasuries, a Mid Office is also essential.
Mid Office will be responsible for implementation of risk management policy,
compliance with risk limits, MIS for top management and market research
as an input for treasury decisions. In banks, Mid Office may also function as
ALCO Support Group, as Treasury plays an important role in asset-liability
management. In Corporate Treasury, Mid Office assume responsibility for
strategic decisions on hedging medium and long-term forex exposures,
including net investment translation risk), valuation of derivatives and
effectiveness testing.
Mid Office ideally should report direct to the CTO / CFO.
12
Integrated Treasury
Integrated Treasury in a banking set-up refers to integration of money
market, securities market and foreign exchange operations.
Till late 90s, investment in securities and foreign exchange business
constituted two separate departments in most of the Indian banks. For reasons
explained below, these two functions have now become part of the integrated
Treasury, thus adding a new dimension to treasury activity.
Integrated Treasury, in the Indian context, is the direct result of reforms
in the financial sector, the most important reforms being deregulation of interest
rates and partial convertibility of Rupee. Rupee is already freely convertible
on current account, and to a large extent, also convertible on capital account,
owing to major relaxations allowed by the Reserve Bank, in the area of foreign
direct investment (FDI), external commercial borrowings (ECB) and overseas
direct investment (ODI) by Indian corporates, and foreign currency operations
of resident Indians. Banks have also been allowed large limits, in proportion to
their net worth, for overseas borrowing and investment.
As a result, banks look for interest arbitrage across the currency markets
and are in a position to shift swiftly, say, a placement in Rupee denominated
commercial paper to lending in USD in global inter-bank market. Banks can
also source funds in global market and swap the funds into domestic currency,
or vice versa, depending on the market opportunities. Banks have gained
wider access to foreign currency funds through their off-shore operations,
NRI deposits, resident foreign currency accounts such as EEFC and float funds
from external commercial borrowings (ECB) of corporate customers. The
banks, do no longer distinguish between Rupee cash flows and foreign currency
cash flows, and an integrated cash flow has become the basis for treasury
operations. Integration of treasuries is directly influenced by globalization of
markets.
To this, we may add the development of domestic financial markets
equity as well as debt with new institutional structure, facilitating instant
payment and settlement systems. As a result, funds can be transferred with
ease from long-term to short-term investments, or from securities market to
money market, or from one currency to another currency. Integrated Treasury
therefore is in a position to operate across the sectors and across the currency
markets, either in search of higher returns, or in order to mobilize low cost
funds for liquidity needs.
13
The same logic also applies to corporate treasuries which undertake
domestic and global transactions, including investments. Corporate treasuries
are generally centralized for group companies, and a central treasury located in
an on-shore or offshore centre will handle treasury operations of all the group
companies. The extent to which individual companies are allowed to operate in
forex and investment markets depends on the delegation of powers within the
group. A common pattern in multinational companies is investment policy and
hedging strategies are approved at group level and centralized treasury directs
operations at unit level.
Indian companies with overseas operations have an added advantage
in that the treasury offshore can handle currency and securities trading with
minimum restrictions in places like Singapore and Hong Kong.
Integrated Treasury operates in different currencies and deals with
different segments of debt and equity markets, generating currency and
interest rate risks or price risk generally referred to as market risk. It is hence
imperative that Integrated Treasury is also fully involved in risk management,
in particular, management of market risk, often using derivative products.
Derivatives help development of financial markets, as availability of a wide variety
of derivative tools is key to managing currency and interest rate risks. The
use of such products is a result of growing link between domestic and global
markets.
III. Globalisation
Globalisation is the process of integrating domestic market with
global markets, characterised by free capital flows and minimum regulatory
intervention.
The capital flows refer to cross-border flow of funds for investment
purpose, which are in addition to regular flow of foreign exchange on
account of trade (exports and imports) and miscellaneous remittances (by
business entities and individuals). The capital flows represent direct and
indirect investments, with the ultimate motive of repatriating returns on such
investments. Capital flows in this sense, involve transfer of wealth, which,
sovereign countries, being sensitive to uneven capital flows, may tend to cap
or regulate with capital controls of varying degrees.
As the economies develop, capital flows are necessarily multi-dimensional,
with overseas companies investing in domestic economy and domestic
14
companies expanding their overseas operations. Funds flow on capital account
may take one or more of the following routes:
Portfolio investment: Foreign investors investing in domestic equity and
debt markets
Direct investment: Foreign companies and foreign institutional investors
investing long-term funds in domestic companies, new projects,
manufacturing facilities, business process outsourcing, etc.
External commercial borrowings
Issue of equity/debt in global markets
Mergers & acquisitions involving domestic and foreign entities
Payment for technology transfer, royalties, financial services, etc.
All the above transactions involve payment or receipt of interest,
fees, dividends and repatriation of capital denominated in foreign currency
sometimes cumulatively referred to as transfer of savings.
World Trade Organisation (WTO) has also contributed to expansion of
global trade by forcing member countries to reduce tariffs, remove protectionist
policies and liberalise trade regulation, under various multilateral agreements.
The economic and financial reforms initiated by India since the early
90s have given impetus to capital markets and the Reserve Bank of India
has been progressively relaxing the exchange controls. RBI now permits large
movement of capital both inflows and outflows either by automatic route
or by delegation of powers to commercial banks, who are authorized dealers.
Foreign currency transactions on current account, which include payment
on account of export-import trade, and miscellaneous payments are fully
liberalized. Government of India has largely removed sectoral caps for foreign
investment, and most of the capital flows now take place by automatic route,
with minimum regulatory intervention. However, recognizing the risks of
uninhibited capital flows, RBI has not yet permitted full convertibility of currency
on capital account.
The capital flows impact money supply, interest rate, exchange rate,
inflation expectations and balance of payment in domestic economy. Though the
capital inflows supplement domestic resources, the impact is not always benign.
Sudden rise or fall in portfolio investments may lead to increase in volatility of
stock prices, interest rates and exchange rates thereby increasing the risks to
15
investors. Domestic economy becomes susceptible to systemic risks owing
to factors like inflation, change in business cycles, regulatory issues and system
failures in foreign countries. The East Asian crisis the systemic failure of
financial markets and erosion of value of currencies in East Asian countries in
late 90s partly caused by massive withdrawal of funds by foreign investors,
has since alerted the Governments and central banks to place some regulation
on cross-border movement of capital.
The immediate impact of globalisation is on the interest rates which are
central to treasury activity whether it is lending, borrowing or investment.
Domestic interest rates are influenced by global interest rate trends, owing
to cross border capital flows, which in turn also influence exchange rates.
In an open economy, exchange rates are influenced by macro-economic
factors like relative inflation, GDP growth rate, stock markets and commodity
markets, even when the central banks tend to manage the volatility by market
intervention.
Globalisation also gives rise to globally compatible institutional structure,
comprising of market regulators (e.g. SEBI, IRDA), market participants (mutual
funds and hedge funds) and financial services such as insurance companies,
various non-banking financial companies, clearing agencies like CCIL, and credit
rating agencies.
As globalisation leads to more complex high-value transactions
denominated in domestic as well as global currencies, a derivatives market
also comes into existence in order to manage the market risks effectively. The
derivatives include currency and interest rate derivatives as also credit and
commodity derivatives, available as OTC (over the counter) or exchange traded
products,.
The globalisation has thus expanded the scope of Treasury and has
thrown open the domestic markets, at least partially, to the winds blowing
across the global currency markets. The impact of globalisation is equally felt by
the banks and financial institutions as also by all other business entities, whether
they are directly involved in global transactions or not.
mmm
16
Concepts behind Foreign Exchange
Arithmetic
Exchange arithmetic refers to the method of calculation of exchange
rates more precisely, it is method of presentation of currency prices which
are market determined. Following are some of the concepts which help us
understand the exchange rate calculation.
Exchange rate is external price of currency, just as interest rate is
domestic price of money. Theoretical discussions will show that exchange rates
and interest rates are interlinked and there are common macro-economic and
global factors which influence the movement of both.
The price of a currency is expressed in terms of another currency, just
as the price of a commodity is expressed. On one side of the quote is a unit
of currency, on the other side is number of units of other currency which can
be purchased or sold. If one unit of US Dollar will purchase 45 units of Indian
rupee, the USD/INR quote is 45.00 (USD expressed in terms of Rupees).
Bid-ask spread is the difference in purchase and sale price, as all of us
prefer to buy at a lower price and sell at a higher price, to keep a margin of
profit. However only market makers like banks (authorized dealers in India)
can quote bid-ask prices: a bank may buy dollars at 44.9850 (bid price) and
sell dollars at 45.0150 (ask price). It must be understood that bid-ask spread is
always in favour of the bank the buy-price of a dollar is the sell-price for the
customer. In the inter-bank market, the bank who quotes the price keeps the
spread in its favour.
Bid-ask spread is important to understand (any) market. In highly liquid
currencies, the spread is very narrow, say only 2 pips in case of Euro/USD. As
the liquidity erodes, the spread widens. A pip is 10000th part of a unit, a basis
point is 1/100th part of a unit. All major currencies, other than JPY, are quoted
in four digits first two digits are basis points, last two digits are pips. In USD/
INR quote of 44.9850, there are 44 units, 98 basis points and 50 pips. JPY is
quoted only in two digits e.g. USD/JPY 77.80, one USD is equal to 77.80 yen
units. (A single quote is always interpreted as mid-rate for the currency.)
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17
Direct quote is when a unit of foreign currency is expressed in terms
of home currency e.g. USD/INR 45.00. Indirect quote is when a unit of home
currency is expressed in terms of a foreign currency e.g. 1 unit of euro is equal
to USD 1.40 only a few currencies like GBP/Euro, Euro/USD and AUD/USD
are quoted in this manner.
In cross currency quotes where home currency (say, INR) is not involved,
the currency to the right side of the quote is known as terms currency and the
currency to the left side is base currency. The usage applies to direct as well
as indirect quotes.
A quote is an indication of the price. Once the quote is confirmed, the
currencies are to be delivered (seller delivers dollars and receives rupees,
the buyer receives dollars and delivers rupees) the process is known as
settlement. Unless otherwise stated, all settlements are spot settlements that
is settlement is done on the 2nd day of trade date.
TOD (or cash) is delivery on the same day (today) and TOM is delivery
next day (tomorrow) the quote is adjusted to net interest for the delivery
period (as compared to spot delivery).
Forward Quotes
A forward contract is a contract for purchase or sale of a currency on a
future date at a fixed rate of exchange. (A future date is a date away from the
spot date of a transaction)
A forward exchange rate is at a premium (costlier) or at a discount
(cheaper) to the spot rate. The difference between spot rate and forward rate
is known as forward premium or forward discount.
A forward contract is essentially a purchase or sale of currency at spot
rate concluded today, with the settlement deferred to a future date. The
net interest receivable or payable for the deferred period is the premium or
discount, which is added or subtracted from the spot rate. Please check the
following illustration.
An exporter enters into a forward contract with a bank for sale of USD
1,000 due to be received after 3 months, say on 16 November, 2011. Spot
reference on the trade date is 45.00.
The exporter has in effect sold USD to the bank at spot rate today, with
settlement taking place only on 16 November, 2011.
18
As the exporter will deliver the USD 1,000 only after 3 months, he has
to pay the Bank interest on USD amount at risk free rate of, say, 0.50% p.a.
for the 3-month period.
The exporter will also receive equivalent Rupees 45000 (at spot rate)
only after 3 months hence the Bank has to pay interest to the exporter at
risk free rate of 5% p.a. for the three month period.
Forward exchange rate is the rate at which the domestic principal +
interest is equal to the foreign currency principal + interest (applying interest
at respective rates of interest) for the forward period.
Forward exchange rate = {45000+(45000*5%*0.25)}/{1000+(1000*0.5%*
0.25)}=45562.50/1001.25=45.5062
Forward premium= 45.5062-45.00 = 0.5062
Forward premium (annualized %)=( 0.5062/45.00)*4= 4.4944%, or 4.5% p.a.
Net interest payable will be forward discount, deducted from the spot rate.
Note that
a) forward premium or discount is expressed in the terms currency (right
side of the quote), and
b) forward premium / discount may be expressed as annualized % or xx units
of terms currency per unit of base currency for the relevant period
In case of major currencies, which are freely convertible, the forward
premium or discount is identical to the interest rate differential of the two
currencies. The underlying principle is known as interest rate parity.
The interest rate parity principle states that when currencies are
freely convertible, the exchange rate settles at a level where there is no net
advantage to a person borrowing in a currency with lower rate of interest.
If a citizen of UK borrows in USD which carries lower rate of interest,
his effective cost will be same as if he has borrowed in GBP, as he will be
repaying more GBP per dollar on a future date (due date), as compared to
the spot GBP/USD exchange rate. He is not benefited by the lower interest on
USD, so long as his underlying requirement is for GBP funds.
The interest parity comes into existence owing to competition in the
markets. In the absence of parity, every one would like to borrow in currency
19
with lower interest cost (USD), thereby increasing the demand for USD and
raising the interest rate of USD at the same time reduced demand for
GBP causing a fall in GBP interest rates - to a level where there is no more
difference in interest rates of USD and GBP. The higher interest cost of USD
is implicit in the higher amount of GBP payable per USD, i.e. forward rate of
exchange where USD is at a premium to GBP.
In other words, interest rate differential is compensated by the difference
in spot and forward exchange rates of the two currencies.
The forward exchange arithmetic based on interest rate parity principle,
leads to the following conclusions:
There is no interest rate arbitrage between freely convertible currencies
the interest rate benefit in one currency is offset by higher / lower rate
of exchange for repayment in another currency on a future date
The currency carrying a lower rate of interest is always at a premium over
the other currency, and
Forward exchange contract in essence is notional lending of currency
bought at spot rate and notional borrowing of currency sold at spot rate.
The exchange arithmetic also shows how the interest rate is embedded
in the forward exchange rate.
As forward exchange contract is actually a spot sale or purchase adjusted
to net interest for the settlement period, the forward exchange rate is not a
forecast of future exchange rate. (In a wider context, however future interest
rate tends to influence exchange rate movements.)
It may however be noted that interest parity principle applies to free
currencies, where there is no exchange regulation. Indian Rupee is only partially
convertible, hence the forward premium is also influenced by supply and
demand for USD, and may not always correspond to interest rate differentials.
Even so, forward premiums broadly follow the interest rate movements.
Cancellation of forward contracts
A forward contract can be cancelled any time before its maturity.
Cancellation is simply reversal of the contract for unexpired period.
A 6-month forward sale contract for USD 10,000 at 46.50 due on 31
December, 2011, entered on 28 June, 2011, is to be cancelled today, say on
20
31 August, 2011. In order to deliver the USD at contracted rate, the client
notionally buys back the same amount value 31 December, 2011 at current
forward rate of say, 47.00 (applicable for the balance period of 4 months). The
client pays to the bank the net amount of ` 5000, discounted to date at money
market rate, upon cancellation of the contract.
Note that the spot rate has no impact and the client has effectively
refunded the difference of premium over the contracted rate for the unutilized
period.
In the net settlement, the client may gain if the forward premiums have
fallen or forward discounts have risen as on the date of cancellation (relative
to premiums on the contract date).
Note also that
a) the bank will quote to the client exchange rates for forward purchase or
sale of currencies with bid-ask spread in its favour, and
b) the bank will apply for discounting net amounts payable, commercial rates
of interest rather than money market rates, for retail transactions.
Cancellation of a forward contract may also take place on due date, if
the underlying cashflow does not happen or is cancelled for whatever reason. In
such a case, the cancellation charges or the net settlement will be equal to the
difference between contracted rate and spot rate as on the maturity, applied
to the notional amount of the contract.
Pre-utilisation of the contract occurs when the client receives or
pays foreign currency on a date earlier to the maturity of the contract. The
settlement is similar to cancellation of the contract, except that actual delivery
of foreign currency takes place at contracted rate instead of notional delivery.
The gain or loss on reversal of the contract for residual period (also known as
early delivery charges) is received or paid by the client, at discounted value.
Rollover of the forward contract for an extended period, is same as
cancellation of existing contract and rebooking of a new contract at current
rates. This may also be expressed as a swap transaction, except for settlement
of cancellation charges.
Assume that the exporter requests on 31 August, 2011 for extension of
the forward contract maturing on 30 September, 2011, for further period of
3 months, say till 31 December, 2011, as the export receivables are delayed.
The steps involved are:
21
Existing contract is cancelled by buying USD forward for 30 September
2011 (residual period) and the client pays (or receives) net amount
(contracted rate current forward rate for residual period).
New contract is booked at current USD/INR rate for forward sale of USD
on 31 December, 2011.
The two contracts together for identical amount (for forward to forward
purchase and sale of USD) booked simultaneously, constitute a currency swap
transaction.
If the client requests for rollover on maturity date of the contract, net
settlement takes place at the difference between contracted rate and spot rate.
A new contract is booked for 31 December, 2011, as requested.
Operationally, holiday convention and local market practices should be
kept in view while concluding a forward contract.
Some illustrations for forward rate calculation
16 August, 2011
Calculate forward exchange rate for sale of GBP three months from
date, given the Spot Euro/GBP at 0.8755, risk-free interest rate# for
Euro at 1% p a and for GBP 0.5% p a
Spot Rate Euro/GBP: 0.8755
3 month Forward Rate : Spot Rate * (1+ GBP Interest Rate)^0.25
(1 + Euro Interest Rate )^0.25
0.8755 * (1+0.5%)^0.25
(1 +1%)^0.25
: 0.8744
Euro interest rate being higher, Euro is at discount.
Calculate forward exchange rate for purchase of JPY 6 months from
date, given the Spot USD/JPY 76.64, risk-free interest rate for USD at
0.5% p a and for JPY 0.35% p a
6 months Forward Rate : Spot Rate * (1+ JPY Interest Rate)^0.5
(1 + USD Interest Rate)^0.5
: 76.64 * (1+ 0.35%)^0.5
(1 + 0.50%)^0.5
: 76.58.
22
Check cancellation charges if the above contract for purchase of JPY,
due on 16th February 2012 is cancelled on 30th September 2011,
assuming on that forward for residual period is 78.30, risk-free interest
rate for USD at 0.5% p a and for JPY at 0.35% p.a.
Contracted Rate for Buying JPY value 16 February 2012: 76.58
On 30 September 2011, Forward Rate for 16 February 2012: 78.30
Cancellation Rate = Difference between the contracted rate and current
forward rate.
i.e. (76.58 78.30) = JPY -1.72
(this needs to be discounted for remaining 4.5 months)
Present Value = 1.72/(1+0.35%)^(4.5/12) = JPY -1.7177
Cancellation charges payable to the bank on 30/09/11: JPY 1.7177 per USD
Check forward rate if the above contract is to be rolled over on
cancellation date for next 6 months, given the Spot USD/JPY 78.20,
risk-free interest rate for USD at 0.5% p a and for JPY 0.35% p.a.
A) Loss on expiry of forward contract on 16 February 2012:
Contracted JPY Buying Rate: 76.58
Spot JPY buying Rate: 78.20
Loss on forward contract: 76.58-78.20= JPY -1.62
B) New forward contract
6 months Forward Rate : Spot Rate *(1+ JPY Interest Rate)^0.5
(1 + USD Interest Rate )^0.50
: 78.20 *(1+ 0.35%)^0.5
(1 + 0.5%)^0.5
: 78.1416
Forward Rate as on 16 February 2012: 78.14. USD interest rate being higher,
USD is at discount (JPY costlier on forward date).
Effective rate on rollover:
Cashflow-wise, the buyer will receive effectively JPY (78.14-1.62)= 76.52 per
USD, after adjusting to the loss on previous contract, which is very near to the
original contracted rate. (interest on loss amount for next 6 months ignored)
# The risk free interest rate is annualized rate quoted for treasuries of required maturity.
mmm
23
Foreign Exchange Risk Management
I. Foreign Exchange Risk
Foreign exchange risk refers to the adverse impact of exchange rate
movements on business profits. The foreign exchange market is global, highly
liquid and is impacted by a multiplicity of factors. As the exchange rates change
from moment to moment, the unpredictability of the exchange rates adds to
the foreign exchange risk enormously.
The exchange rate determines the value of a cashflow denominated in
foreign currency, in terms of domestic currency. The cashflow may reflect an
asset or liability (balancesheet exposure) or an export receivable or a payment
due on import (revenue exposure). An appreciation in the value of foreign
currency is positive for an exporter (e.g. Rupee value of USD receivable goes
up), but negative for an importer (e.g. increase in cost of imports from Japan).
Depreciation of foreign currency or appreciation of domestic currency, on the
other hand, has the opposite effect. To appreciate the foreign exchange risk in
all its facets, it is important to understand the nature of the risk, the context
in which the risk arises and how the risk impacts the business.
Foreign exchange risk is part of market risk
A distinction may be made between business risks and market risk. A
business risk is largely internal to the business, where the management may
consciously decide on the business model, and has a fair amount of choice in
selection of product or service, sourcing of raw material, marketing strategy,
financial closure and employment of human resources. Market risk is external
to the business entity, and the Management has no choice but to accept the
exchange rates and interest rates (which also include other tradable asset
prices) as determined by the market. Managing market risk is hence much
more complex than managing the business risks.
Foreign exchange market is arguably the most efficient market, where
no single entity can influence the exchange rates. In a regulation free currency
market (ref. all major currencies), even central banks have only a limited role
to play. It would be interesting to see how even massive intervention by central
3
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24
banks has only a ripple effect, with the impact on exchange rate movement
limited to a few hours, or in exceptional cases only a few days. Given that daily
forex turnover in a single market like New York is near about USD 1 trn no
central bank has enough resources to make a lasting impact on the currency
rates. (check annexure for latest intervention by Bank of Tokyo)
Market risk comprises of exchange rate risk, interest rate risk and price
risk. Essentially it is the interest rate risk which transforms in to exchange rate
or asset price risk, depending on the type of cashflow. However, the strategies
to deal with each of the risks, and the instruments available to hedge such risks
differ from market to market. It is assumed that all the markets are largely
regulation-free and are fairly liquid. (As stated earlier, market for free currencies
is most liquid market.)
Foreign exchange risk is a cashflow risk
Risk arises out of cashflow mismatches. A currency mismatch gives rise
to exchange rate risk, while maturity mismatch gives rise to interest rate risk.
A cashflow denominated in foreign currency, and is due to take place on a
future date has exchange rate as well as interest rate risk. We have seen how
interest rate differentials of two currencies get embedded in their forward
exchange rates.
Currency mismatch is present, when cash inflow (e.g. export income)
is in one currency and cash outflow is in a different currency (e.g. employee
salaries). Assume that revenue from exports to US is budgeted for the year
2010-11 at ` 100 mn. which is expected to meet 40% of the operational
expenses. Assume that 100% of the export sales target is achieved in USD
terms, but Rupee realization amounted to only 85 mn owing to depreciation
of dollar during the year. There is thus a funding gap or loss of business
income entirely due to adverse movement of exchange rate. Of course, if the
rates move favourably, there could be addition to business income, or export
department can claim to have crossed the targeted sales in rupee terms.
Cashflows denominated in foreign currency are measured in terms of
domestic currency or reporting currency. In free market countries, companies
can draw balancesheet accounts in any currency of their choice, but for
reporting purposes, they must translate the accounts in to prescribed currency,
which is normally domestic currency. Thus a company in UK can opt to have
a dollar balancesheet, but it must report to regulatory authorities balancesheet
translated in to GBP. The USD is called the functional currency and the GBP,
the reporting currency.
25
Currency mismatch is present when functional currency is different from
reporting currency.
Foreign exchange gains/losses are to be viewed in a specific context
All foreign currency cashflows are measured in domestic currency (or
reporting currency) at current exchange rates, or at their mark-to-market value
for accounting and risk management purposes. The measurement of change in
the value of a FC cashflow, on account of change in exchange rates has the
following implications.
The value of a FC cashflow as on a given date may differ from the value
as at inception of the transaction. Assume that an export was invoiced for
USD 1,00,000 three months back, at then prevailing USD/INR spot rate
of 48.00. The receivables are due on 31 December, 2011. At quarterly
valuation as on 30 September, 2011, the MTM value of the cashflow, say
at current forward rate of 46.00, shows a notional loss of ` 2,00,000.
The notional loss will be debited to the P&L account and will reduce the
business profits for the quarter.
The implication is that a cashflow denominated in foreign currency may
result in valuation gains or losses, owing to exchange rate fluctuations, that
leads to volatility of profits even when the cashflow is not yet due
On the due date, the export proceeds will be converted in to rupees at
current spot rate, say at 47. The difference between the exchange rate as
at inception (booked rate) and realised rate may show a cash loss or cash
gain in this case a loss of ` 1 which is recognized in the P&L accounts.
This is only an adjustment to the booked rate, based on realization at
current market rates.
The real implication is that the expected value of the FC at the time of
accepting the export order at a targeted rate and the realized value at
current spot rate will not be the same. The target rate may be the budget
rate, the forward rate or a user-defined rate, and not necessarily the
booked rate.
Assume that the exporter had budgeted his profits from export business
based on a minimum conversion rate for USD/INR at say, 47.50. Realized
rate of 46 is less than the budgeted rate by Re. 1.5 per dollar as on 31
December, 2011. The budgeted profit will therefore, get eroded by Re
1.50 per USD, or in the above illustration, by ` 1,50,000.
26
We thus have foreign exchange gains and losses described in three
different ways:
Valuation changes Current valuation vs. previous valuation (or value at
inception)
Accounting impact Realised value vs. value at inception
Business income Target value vs. realized value
Needless to say, for the purpose of FX Risk Management, impact on
business income on account of variation of exchange rates from a pre-set target
rate is considered to be most important.
If we define foreign exchange risk as the probability of loss of income
on account of adverse fluctuation of exchange rates, the loss may not always
be quantifiable, or confined to the loss measured as above. The loss may also
manifest as loss of competitive advantage, or change in composition of business
or a reduction in distributable profits (even if cash profits are not affected). It
is hence necessary to understand the type of risk a business entity faces on
account of exchange rate variation.
Generally three types of exchange risk are identified:
3 Transaction Risk
Transaction risk is transaction specific where change in exchange rate
directly affects the cashflow. The gain or loss described in the above illustrations
is transaction specific and is imminent as and when the cashflow takes place.
The exchange rate is used for conversion of the FC cashflow at inception and
on realization, as also for setting target rates.
3 Translation Risk
Translation risk refers to change in the value of assets and liabilities,
denominated in foreign currency, on account of variation in exchange rates,
even when there is no underlying cashflow during the reporting period.
A USD loan is initially booked at the drawdown value in reporting
currency at, say, current spot rate of 45.00. On reporting day, the loan
is revalued at closing rate of, say, 48.00. The liability in the balancesheet
increases by ` 2 per USD or by about 4.5% even when there is no change
in USD value of outstanding loan. The increase in the liability is transferred to
27
a corresponding asset account, or to the P&L account as per the accounting
convention. In either case the composition of balancesheet (e.g. debt to
equity) undergoes a change, and in the latter case the distributable profit is
also reduced. Similar is the impact of gain or loss in valuation of an overseas
investment, except that the change in value is held in a reserve account without
affecting the operating profits.
Translation risk is significant for multinational companies where quarterly/
annual valuation of their net investment in overseas subsidiaries is affected by
exchange rate movements.
3 Economic Risk
A business entity may have exposure to foreign exchange risk, even if it
has no dealings in foreign exchange. A power plant may buy coal locally, but the
coal prices may be impacted by appreciation of Australian dollar, as Australia is
one of the largest exporters of coal, as also of other commodities like iron ore
and copper. Sugar manufacturers may face the price risk, if global prices crash
on account of high inflation in Brazil leading to depreciation of Brazilian Real.
Garment manufacturers are always worried about competition from China, as
China defers revaluation of its currency.
Economic exposure is indirect exposure to fluctuation in exchange rate of
specific currencies, which may impact competitive strength of a business entity
in domestic/global markets. Economic exposure is significant in markets where
there is a dominant player in global markets, influenced by currency prices.
We may also define type of risk from enterprise point of view:
Balancesheet exposure is exposure to variation in value of foreign currency
assets and liabilities (e.g. FC loans and overseas investments), and Revenue
exposure is exposure to change in value of cashflows from exports and
imports, and other payments/receipts on current account. Translation risk is
confined to balancesheet items, while economic exposure is for the business
entity as a whole. Transaction risk is present in all cashflows, whether they
pertain to trade receipts and payments, or loan repayments/redemption of
investments denominated in foreign currency.
II. Risk Management
The exchange risk is to be managed with a view to minimize impact of
adverse fluctuation in exchange rates and interest rates.
28
It is for the corporate management to adopt a conscious strategy to
manage the currency exposures. It is always preferable and mandatory for
listed companies to have a documented risk management policy. FX risk
management is part of overall risk management and hence should be consistent
with other policies like liquidity management and investment management.
A FX Risk Management Policy should deal with all aspects FX business of
the company. Following steps are involved in developing the Policy;
A. Exposure Identification
An exposure to currency markets can be identified at different stages.
For instance, the exchange risk in import of a commodity may be identified
At the time the import order is placed
When the LC is opened, or
When the shipping documents are received
Similarly, an exporter may recognize the risk when the order is
confirmed, when the LC is received or when the shipment is made.
The exposure to currency risk commences as soon as the price in
foreign currency terms is committed irrevocably that is when the import or
export transaction is confirmed and is binding. The price in terms of, say, USD
is the basis for the exporter or importer to determine the rupee value of the
transaction and the resultant operating margin or cost of production.
Ideally, the exposure is therefore, to be identified at the inception, when
the price in FC is agreed upon, for exports and imports.
There could however be different approaches in this regard. Some
entities, based on the nature of business, may prefer to identify the exposure
only when the invoice is drawn, i.e. only for the credit period. Some others
may consider commencement of the budget period as commencement of risk
for budgeted exports and imports, since the rupee values are estimated at that
point of time.
Exposures include current as well as forecast future exposures (future
receivables/payables). The projections may be based on orders under
negotiation, business prospects, or budgeted estimates. The relevant date of
identification of exposures is the date on which the estimates are finalized in
terms of their Rupee value.
29
The exposure identification may also be different for balancesheet
exposures. Risk in a FC loan may be identified on draw-down date, or earlier
when the loan was approved, or even earlier when the project cost (to be
funded from the loan) is estimated.
The Risk Management Policy should specify at what stage the forex
exposures are to be identified for monitoring, measuring and hedging the
exchange rate risk separately for revenue exposures and for balancesheet
exposures.
B. Target Rate
Next stage is setting a target rate. An exchange rate is good or bad only
relatively, e.g. todays USD/INR rate is better than yesterdays, as Rupee has
appreciated. It is necessary to set a benchmark, based on which we would
know whether an exposure has gained or lost in value at current market rates,
or alternatively, whether we have a gain or loss in real terms upon realization
of the cashflow.
Two issues are involved: one issue is, what is the right time to set up the
target rate, the other is, how to select or structure a target rate.
Indisputably, the right time to set up the target rate is the time when
the exposure is identified, either at inception, or at budget time as described
above. It is the time when the exporter or importer has the expected rupee
value of the trade in mind. Since the expected Rupee value would somehow
connect to market rate as at inception of the exposure, target rate decided at
any other point of time runs the risk of being out-of-the market.
The target rate can be spot rate or forward rate or any other rate based
on the market rates prevailing at the time of the exposure identification. The
target rate needs to have a link with the market rate, as otherwise, it would
be difficult to protect the target rate till the due date of the cashflow.
Target rate can be (and usually, is) a user-defined structured rate. For
instance, an importer may set up forward rate + 2% as target rate for an
import payment due after 6 months, the assumption being that there could be
minimum 2% movement in exchange rates over next 6 months. He would then
arrive at rupee cost of his import at current USD/INR forward rate of, say,
46.00 + 2% =46.92. Effectively he has added market risk at 2% to his cost,
which would be built in to his product pricing. An exporter would similarly
reduce the cost of risk from the forward rate, and build in into his product
30
pricing or forecast revenue in Rupee terms. The base rate could also be spot
rate, in place of forward rate. The margin over the base rate can be in %
terms (as above) or in absolute terms (e.g. spot rate + ` 2). The margin is
added to base rate for cash outflows (creditors), and deducted from base rate
for cash inflows (receivables).
The cost of risk or the risk margin included in the target rate can be
arrived at in different ways. The risk margin could be a) subjective perception
of market movement, or, a view on the market, or b) market volatility based
on a statistical measure like VaR, or c) cost of risk as indicated by the premium
payable on a ATM plain vanilla option, or d) any other measure. Target rate
based on a budget rate can also arrived at in similar fashion (i.e. spot rate or
forward rate as at commencement of budget period + / - cost of risk)
Target value is exposure amount multiplied by the target rate. Treasury
is expected to protect the target value in such a way that the realized value
on the due date is not worse than the target value. There are some practical
considerations in choosing a structured target rate or a risk-adjusted exchange
rate rather than plain spot or forward rate as the target:
If target rate is spot or forward as at inception, the Treasury will be
bound to lock into that rate by hedging forthwith as the rate will certainly
be different next day. This will deprive Treasury of any benefit from favourable
rate movements later, and would also result in higher hedging costs.
The cost of risk is akin to cost of hedging. By building hedging cost in
to forward rate, product pricing is made more rational and hedging cost is
recovered from the counterparty, as part of the price.
The risk margin allows Treasury breathing time to consider hedging based
on market conditions. Treasury will not hedge so long as the market rate
is better than the target rate, thus minimizing hedging cost.
Mark-to-market value of open positions (unhedged exposures) is
monitored in relation to the target value, to discover potential gain or loss
on a given date.
Target rate described above is transaction-specific. A uniform target rate
can also be arrived at for a portfolio of receivables or payables, based on
their estimated due dates. For instance, export receivables are grouped
into monthly time buckets corresponding to their estimated date of
collection, and target rate can be fixed adding / deducting the required risk
31
margin to forward rate for each month. A weighted average of target rates
for the period covered (6 months or 1 year) will give a uniform target rate
to be protected by Treasury. Target rate for a budgeted period can also be
arrived similarly.
Target value is always a conservative estimate of future revenue (or costs),
hence projected business profits are more realistic.
There would be similar process for setting target rates for FC loan
exposures say, current Rupee value of the loan, or swap rates for principal
and interest amounts with or without a risk margin.
The Fx Risk Management Policy should prescribe the method to set up a
target rate, either transaction-wise or portfolio-wise, based on the requirement
of underlying business.
C. Hedging Strategy
Target Rate can be protected only if the FX exposures are hedged
appropriately. Hedging strategies are case-specific and there could be several
approaches to hedge the exposures. To illustrate
Zero-risk approach: If exposures are fully hedged at inception, say by
buying forward contracts or plain vanilla ATM options, there will absolutely
be no risk of loss as compared to the target rate. However, there is
opportunity cost in case of forward contracts, and upfront premium cost
in case of options.
Mandatory hedging: The hedging strategy may include a minimum
mandatory hedging (say, 30% of the exposure at inception), with balance
left open until the market movements threaten the target rate.
Open position: Entire exposure may be left open (unhedged) subject to
monitoring the risk based on daily MTM values.
Portfolio hedging: The hedging strategy may be applied to each (export/
import) transaction or to a portfolio of transaction, distributed into time
buckets (monthly/fortnightly), corresponding to their due dates.
Net exposures: A business entity may opt for hedging only net exposures
(cash inflows less cash outflows, or exports less imports maturing for
payment in a given period) also known as natural hedge, in order to save
hedging cost. Cashflow mismatches, however, may have an opportunity
cost.
32
The FX Risk Management Policy should recommend hedging strategy
most appropriate to the underlying business. The hedging strategy needs to be
defined separately for managing balancesheet risks. For companies with large
portfolio of foreign currency loans, it is preferable to have a separate Liability
Management Policy.
D. Hedging Instruments
Hedging Strategy may require use of specific hedging instruments, which
are derivative products, under specific market conditions to hedge specific type
of risks. Hedging instruments are basically forwards and options, falling in to
one or more of the following description:
Forward Products
Forward Contracts (currency risk)
Currency Swaps (currency & interest rate risks)
Interest Rate Swaps (only interest rate risk)
Forward Rate Agreements (only interest rate risk)
Currency Futures (exchange traded)
Interest Rate Futures (exchange traded)
Option Products
Plain Vanilla Options (currency risk)
Caps & Floors (currency/interest rate risks)
Various other combination of options (Range forwards, Participating
forwards, Put/call spreads, etc.)
The hedging instruments available in the market range from plain vanilla
forwards and options to exotic structures combining elements of options and
swaps. The Policy should lay down permissible instruments, satisfying minimum
criteria as under:
a) Liquidity The selected instrument should have a liquid market, with easy
exit route, in case the hedge is no longer required. Liquidity also implies
narrow bid-ask spreads and competitive quotes from counter-party banks.
33
b) Worst-case Loss Derivatives generate their own risks. The structure of
the instruments and the pricing components should be well understood,
and any loss from select instruments should be quantifiable. Open-ended
instruments with unspecified losses should be avoided at all costs.
c) Accounting Requirements If the selected instrument is not qualified
as hedge instrument under accounting guidelines, the use of instrument
would amount to speculation, and may result in trading losses.
d) Regulatory Compliance Central banks and monetary authorities
impose restrictions on use of derivatives, so as to protect the interests of
the users. Such regulations should be complied with, in letter and spirit.
e) Margin Calls While exchange traded instruments do not entail any
counterparty risk, the margin calls may stress the cash resources of the
entity if the market volatility is exceptionally high. The impact on liquidity
should not be underestimated, as quite a few companies have failed only
on account of their inability to meet margin calls in time.
For companies who use derivatives extensively, it is advisable to have a
Derivative Policy, more elaborately dealing with pricing, valuation and accounting
aspects.
E. Risk Monitoring
FX Risk Management policies do not normally stipulate 100% hedge
at inception of the exposure. The exposures in part or in full are left open
in order to capture market opportunity, in case the exchange rates move
favourably. The risk in open positions needs to be monitored continuously, so
that sudden adverse movements do not eat into business profits.
Risk monitoring involves the following steps;
Adopt target rate as benchmark for measuring the risk.
Arrive at target value, by applying target rate to the open positions.
Open positions are to be marked-to-market (MTM) daily. The MTM value
is arrived by applying current forward rates, corresponding to respective
due dates of open positions. The MTM value is the value that can be
notionally locked into as on date of valuation, by entering into forward
exchange contracts.
34
The risk is if the MTM Value is worse than the Target Value target rate is
protected if MTM value is higher than target value in case of exports, and
vice versa in case of imports. If the Target value is likely to be breached,
open position must be hedged in full or part, as required under the Risk
Management Policy.
It is imperative that the treasury should have sound systems to monitor
the risk, in case significant parts of FX exposures are left unhedged.
Risk Limits
Difference between the MTM value and target value indicates potential
gain or loss in open positions.
In normal course, the Treasury should hedge if the exchange rates move
adversely threatening the target value. However, there are occasions when
markets have a correction in a short while, and high volatility of rates may only
be a temporary condition. In such a case, immediate hedging may become a
knee-jerk reaction.
Keeping the market behaviour in view, the Policy may prescribe a stop-
loss limit or a tolerance level, beyond which hedging is warranted. Hence, even
if there is potential loss based on MTM value of open positions, Treasury may
wait till the stop-loss limit is threatened. In case of market correction, Treasury
will not have to forego the benefit of favourable rate movements.
It is important that the Treasury must have the discipline to hedge open
position, once the stop-loss limit is threatened, without taking a further view
of the market.
The stop-loss limit is to be set up based on the entitys ability to absorb
losses, or its risk capital the portion of capital that can be used to fund
treasury losses.
The Treasury does not normally hedge the open position if the exchange
rate movement is favourable, and in Treasurys perception, if the favourable
trend is likely to continue for some time. The Policy may however, prescribe
a take profit limit (say, when market rate for USD/INR is better than target by
` 2), beyond which the Treasury must hedge the open position in full or part.
The take profit limit is intended to lock into a profit without missing the good
levels based on a view.
35
Within the band of stop-loss and take profit limits (say between target
rate-` 2 and target rate+` 2 for USD exports), Treasury may take a view of
the market and may or may not hedge the open positions. It will be mandatory
to hedge only if either of the limits is breached.
Project Exports
FX Risk Management Policy generally deals with revenue exposures
which are of short-term duration normally confined to a working capital cycle
of 3 to 6 months.
Project exports on the other hand, involve construction and management
of large projects overseas, mostly in infrastructure and basic manufacturing
sectors. Large engineering and construction firms, and project equipment
manufacturers with good track record, secure the overseas projects after
successful bidding, in competition with global vendors. The project exports may
take the shape of
Turnkey projects where the contract is for delivery of entire project,
built from scratch
Civil and Engineering construction normally sub-contracted by the
project managers
Project equipment export of plant and machinery, part of which may
be built or assembled at project site
Project Management / Technology Transfer Mainly export of
services, may involve maintenance services, quality inspection, technical
collaboration, etc.
The project exports typically run for 1- to 5-year period, and involve
payments spread over the project completion period generally not supported
by LC arrangement. The risks associated with project exports are varied and
are more complex to manage as compared to risks associated with trade
exposures. Some of the risks that need specific attention are:
Pricing Risk A firm quote at the time of bidding is based on current
exchange rates. The lead time between the bid and allotment can be as
long as 6 to 9 months, during which period the exchange rates as also the
cost composition may undergo a change. However, once successful, it will
be difficult to renegotiate the bid price.
36
Multi-currency exposures Apart from exposure to project fee to be
received in foreign currency, the exporter may also have to meet local
expenses at project site in local currency, provide for direct import from
third countries in respective currencies, and outsource some of the
technical services to other local / global firms.
Milestone payments Payment for projects are linked to the progress of
the project. In case of cost and time over runs, the payments get delayed
with implications on a) exchange value and b) liquidity management
where the project exporter may have to bridge the funding gaps with
short term local / FC borrowings.
Project funding The project exports may have to be funded from
multiple sources ranging from FC term loans to suppliers credit on
equipment purchases. The possible issues are drawdown corresponding
to project requirement, currency mismatches and variable funding costs.
Political risks While political risks are present in all overseas transactions,
including exim trade, the risks are much more significant in project exports,
which constitute long-term exposure to market risks. The milestone
payments or final payment for the project may not be forthcoming on due
dates and may even be delayed indefinitely, owing to a regime change or
civil disturbances or war. Foreign exchange risk over the delayed period can
not be hedged easily, even though the credit risk can be taken care of by
export guarantee and insurance companies. In the recent past, Indian project
exports to countries like Iraq, Sudan and Libya have suffered on this account.
FX Risk Management Policy should have distinct provisions to meet the
challenges of project exports. Hedging strategies need to be designed for each
of the high value projects based on the provisions in the project contract,
tenor of the payments and the financing arrangements. Some of the common
approaches include negotiating exchange rate protection clauses, minimizing
currency mismatches with funding arrangements in respective currencies,
hedging on net exposure basis (net of FC funds received in advance, funds held
in overseas accounts and import commitments), and fixing costs of medium and
long term liabilities. Treasury also needs to look at yield enhancing structures
for FC deposits held abroad.
III. Regulatory Environment
FX Risk Management Policy should provide for hedging strategies and use
of derivative instruments within the existing regulatory framework.
37
Reserve Bank of India regulates use of Rupee and forex derivatives.
Exchange Control regulations are largely dispensed with, Rupee being fully
convertible for current account transactions. RBI, in line with Governments
policy, controls only capital flows, which take the form of ECB, portfolio
investment, foreign direct investment (FDI), overseas direct investment and
related remittances.
Foreign Exchange Dealers Association of India (FEDAI) is a self regulatory
organization promoted by banks, and works closely with RBI. FEDAI establishes
market practices, code of ethics and operational instructions for application
of interest, overdue charges, etc. FEDAI also provides statistical measures of
VaR and exchange rate volatility, based on market quotes, for use of member
banks. Following liberalization of exchange controls, FEDAI guidelines relating to
merchant quotes, bid-ask spreads, customer charges, etc. are no longer binding
on the banks.
Fixed Income Money Market Derivatives Association (FIMMDA) of India
is another self regulatory organization, mainly operating in Rupee market,
dealing with benchmark yields, valuation of securities, market practices for
interest rate derivatives, issue of money market instruments etc. FIMMDA
and FEDAI together vetted and standardized the ISDA Master Agreement for
Derivatives, for use of Indian banks.
FEDAI and FIMMDA, as SROs, interact with RBI on regular basis, and
function as vehicles for introducing new products and implementing market
reforms.
SEBI (Securities Exchange Board of India) controls stock exchanges
where currency and interest rate futures are traded. All the currency futures
are subject to Rupee settlement only, hence there is no direct impact on
exchange rates. SEBI regulations are oriented towards managing the risk of
stock exchange as counter party, through collection of margins, monitoring
volatility and checks on brokers. Currency and interest rate derive products are
introduced in the exchanges only after they are approved by RBI.
The regulatory provisions for use of OTC and exchange traded
derivatives are detailed in the following Parts.
RBI does not control corporate sector. RBI issues guidelines to banks,
and those guidelines become binding upon corporates as they have to deal with
only banks as counterparties for foreign exchange and derivative transactions.
Important guidelines issued during the years 2010 & 2011, and bearing upon
risk management activity are summarized below:
38
To use derivative instruments, a company must have a Board-approved
documented FX Risk Management Policy, a copy of which is to be
produced to the bank.
A derivative can be used only for hedging risk in an underlying exposure,
current or future.
Future exposures or projected business is permitted only to an extent
of 100% of previous years exports / imports, or average of last 3 years
exports / imports whichever is higher. The past performance limit is a
one-time limit, and is not replenished if a forecast exposure is subsequently
converted into a confirmed order.
Forward contracts and options with current underlying exposures are
allowed to be cancelled and rebooked freely.
Forwards and options based on past performance, can be cancelled
(before maturity) only to the extent of 75% of the permitted limit, and
cannot be rebooked.
FC : Rupee Derivatives used to hedge currency and interest rate risks of
FC loans, once cancelled, can not be rebooked.
Exotic options using barriers and digitals are not permitted.
Only listed companies or unlisted companies with minimum net worth of
` 200 cr are permitted to use cost reduction structures, or swapping of
Re loans into foreign currency.
Provisions governing Project Exports are covered in the Memorandum
of Instructions on Project and Service Exports (PEM) last issued by RBI in
October, 2003, partly amended in January 2007. PEM provides guidelines for
approval of projects, funding and operating offshore accounts, but does not
cover managing the forex or credit risks. Important provisions of PEM, as
amended to date, are summarized below:
In terms of FEMA (Export of Goods and Services) Regulations 2000, export
of goods or services on deferred payment terms, or in execution of a
turnkey project or a civil construction contract requires prior approval
from an authority appointed by RBI.
Project export contracts and service export contracts up to USD 100 mn
may be approved by the AD bank or EXIM Bank. Projects exceeding USD
100 mn need to be approved by the Working Group headed by EXIM
Bank.
39
Period of deferred credit can be determined by the exporter in
consultation with his bank, based on commercial judgment.
Working Group, consisting of representatives of RBI, ECGC, Govt of India
and bankers is empowered to give single window clearance for all related
approvals regulatory clearances, credit approval, and approval from
ECGC, etc. for project and service exports.
The Exporter is allowed to have a single account at an offshore centre in a
currency of his choice for all the overseas projects being executed by him.
The exporter is also allowed to invest surplus FC funds in bank deposits,
approved securities and money market instruments, having minimum credit
rating as prescribed in the PEM.
The Exporter however is required to maintain Project-wise accounts and
remit profits to India as soon as the project is executed.
Under Risk Management Guidelines of RBI, the FX risk of project
exports can be hedged at all stages, including at the time of submission of bid
for the project.
A comprehensive FX Risk Management Policy should provide clear
guidelines on regulatory, accounting and documentation requirements, some of
which are dealt with in the following sections.
40
Annexure 1
Impact of central banks intervention
Bank of Tokyo intervened in markets on 4th August to stop further
appreciation of JPY.
mmm
41
Derivatives - 1
Introduction to derivatives
Derivatives are widely used by Treasuries to hedge market risks, viz.
currency and interest rate risks. Derivatives are also traded to extract benefit
from underlying market movements. In India, only authorized banks as market
makers are permitted to trade in OTC derivatives, while trading in exchange
traded derivatives is open to all. Corporate treasuries are increasingly using
commodity derivatives also to hedge against price risk.
A derivative is a financial contract, specifying an underlying which is a
price or rate or an index related to a financial product or market, based on
a notional amount and/or specific payment provisions, with clear settlement
terms. By definition, derivatives always refer to a future price and the value of
derivative depends on spot market.
A derivative, as its name suggests, does not have an independent
value. The value of a derivative is derived from an underlying market. The
market may be financial market, or commodity market, or an index of market
prices. Financial markets relate to products such as foreign exchange, bonds
and equities. Forward contracts for exchange rates, conventionally used by
exporters, importers, traders and banks are also part of derivative family. An
extended form of financial derivative is credit derivatives, with credit risk of
lenders and investors as underlying product. Commodity markets may cover
any commercial product, ranging from oil and gold to cotton and wheat.
Derivatives are also in use in non-conventional markets like energy trading and
carbon trading.
RBI (Amendment) Act of 2006 defines a derivative as under:
A Derivative means an instrument, to be settled at a future date,
whose value is derived from change in interest rate, foreign exchange rate,
credit rating or credit index, price of securities (also called underlying), or
a combination of more than one of them and includes interest rate swaps,
forward rate agreements, foreign currency swaps, foreign currency-rupee
4
CHAPTER
42
swaps, foreign currency options, foreign currency-rupee options or such other
instruments as may be specified by the Bank from time to time.
Vide its Guidelines issued in April 2007, RBI also approves the definition
of derivative appearing in the Accounting Standard IAS 39 under IFRS:
A derivative is a financial instrument:
(a) whose value changes in response to the change in a specified
interest rate, security price, commodity price, foreign exchange
rate, index of prices or rates, a credit rating or credit index, or
similar variable (sometimes called the underlying);
(b) that requires no initial net investment or little initial net investment
relative to other types of contracts that have a similar response to
changes in market conditions; and
(c) that is settled at a future date
The essential features of a derivative, based on the above definitions, are
summarized below.
Derivative is a financial instrument it is a financial contract between
two counterparties, with agreed terms for settlement
Settlement on a future date settlement takes place on a future date,
or during a future period (as defined in the contract) away from spot date
Change in price the price of the derivative changes, in response to
changes in the underlying
The underlying the underlying is a market price or rate, implying one
or more of the following:
At any point of time, the price or rate is discovered in a liquid
market
The price or rate or the index is determined objectively, in a
transparent manner, and
The benchmark price/rate/index is acceptable to all market
participants
No initial investment or net initial investment Initial investment for
purchase of a derivative should not be large, say, as compared to notional
amount on which the benefit from the derivative implies a return. In a
43
hypothetical case, if you are required to deposit USD 90,000 to buy a
3-month forward sale contract for USD 1,00,000, it ceases to be a hedge.
Prepayment of one leg of a swap deal at present value also disqualifies
the swap as a hedging instrument. An insurance contract is not a hedge as
cumulative premiums will be near about the insured amount.
OTC and Exchange Traded Derivatives
Derivatives are broadly classified into over-the-counter (OTC) products
and exchange traded derivatives (ETD), based on the platform on which they
are acquired and traded.
Banks structure a derivative product to suit the requirement of a
business entity based on its risk appetite, size of transaction and maturity
requirements. For instance, a bank may offer to a client a forward contract
or option for sale of USD on a future date, for whatever period or amount
desired by the client. The derivative products that can be directly negotiated
and obtained from banks and other financial institutions are known as Over-
the-Counter (OTC) products.
There are also standardized derivative contracts, for a specified sum
and for specified period, which are purchased or sold on a exchange. These
are exchange traded derivatives, traded on a futures exchange. A forward
contract traded on a futures exchange is called a futures contract. Exchange
traded derivatives include currency futures, interest rate futures, commodity
futures, stock and index futures, as well as currency/interest rate, commodity
and stock options. Some of the futures exchanges are organized independently
(e.g. CME Group, LIFFE, MCX-Sx) or at times function as part of stock
exchange (e.g. Hong Kong Exchanges & Clearing, Singapore Stock Exchange,
NSE in India).
OTC products are different from exchange traded products in the
following respects:
OTC Exchange Traded
OTC products are offered by banks
and financial institutions (need to be
authorized banks in India)
Futures contracts are traded only on
organized futures exchanges
Contracted date, amount and terms
as desired by the client
Size of contract is standardized, with
pre-set settlement dates for specific
contracts
44
Bank Treasuries and corporate customers of the bank mostly use OTC
products such as forward contracts, options and swaps. Futures exchanges
are generally used for trading and speculative purposes. Larger banks may use
futures exchanges also for hedging their residual positions, or for arbitraging
between OTC and futures markets. Currency futures and options traded on
futures exchange largely tracks the pricing of OTC products, as OTC market
is much deeper, leaving little scope for arbitraging.
In this section we would be discussing only OTC products in the financial
market, unless otherwise stated.
All derivative products, whether pertaining to currency/interest rate or
commodity markets, fall into one of the two categories:
Forwards, and
Options
Forward products are forward contracts with a fixed rate, where the
buyer of the contract must exercise the contract on its expiry (or cancel it
earlier).
OTC Exchange Traded
OTC products are obtained from the
bank/institution directly
Futures exchanges can be accessed
only through broker-members
Price is quoted by the Bank, adding a
margin to market quote
Transparent pricing, based on screen-
based order matching system, with a
negotiated brokerage
Security (cash margin, charge on
assets, etc.) at banks discretion,
based on client status
The Exchange collects daily cash
margin based on MTM value of the
contract
Counter-party risk (bank risk) is
present
No counter-party risk, as Exchange is
the counter party who manages the
risk by margining system
Settlement is mostly by physical
delivery (net settlement only in
trading positions/cancellations)
Mostly net settlement by cash
(physical delivery may be insisted upon
in commodity futures)
Mostly used for hedging underlying
risk
Mostly used for trading and
speculation
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Options are financial contracts where the buyer of an option has no
obligation to exercise the contract on or before its expiry.
There is a third kind of derivative known as
Swaps
Swap as a hedging instrument is in essence, a combination of two
forward contracts where both legs of the transaction must be exercised on
the due date.
An outline of the three kinds of hedging products is presented below.
1. Forward contract
Forward contract is a contract to deliver foreign currency on a future
date at a fixed exchange rate. This is a OTC product where the counterparty
is always a bank. Forward purchase or sale contracts can be used to hedge
currency risks in cross-currency deals also, as forward contract being simplest
of the derivatives, is available in most currencies.
Delivery of currency must be given or taken, as per contract terms,
on the expiry date of the contract, otherwise the contract will be cancelled
and the difference between spot rate and forward rate will be credited to or
recovered from the counterparty. Forward contract can be pre-utilised, subject
to bank charges which comprise of a) adjustment of premium for unexpired
period of the contract, and b) interest or discount for the residual period on
net payment. A rollover of forward contract implies cancellation of the existing
contract and rebooking of a new contract at current rates.
On request banks may allow delivery to take place within a month
before the expiry date. This facility is known as forward option, where bank
would quote forward premium (discount) applicable to either start date or end
date of the option period, whichever is worse to the client.
The difference between forward rate and spot rate, as stated earlier,
represents interest rate differential of the two currencies. The forward rate is
either at premium or discount to the spot rate. The currency carrying higher
rate of interest is always at a discount. In case of free currencies, forward
premium or discount is exactly equal to the difference between risk-free
interest rates of the two currencies. However, in case of USD/INR, it is not
always so, as Rupee is not yet fully convertible. The forward exchange rate of
USD/INR, therefore is also affected by supply and demand for forward dollars.
46
Forward contract is ideal as a hedging instrument to achieve zero risk,
as the contracted rate fixes the value of forward dollars, irrespective of market
movement. However, the holder of a forward contract cannot get the benefit
of market rate, if it is better than the contracted rate, on the date of utilization
which is a disadvantage known as opportunity cost.
2. Options
Options refer to contracts where the buyer of an option has a right but
no obligation to exercise the contract. Options are either put options or call
options. Put option gives a right to the holder to sell an underlying product
(currency/bonds/commodities) at a prefixed rate on a specified future date. Call
option gives a similar right to the holder to buy the underlying at a prefixed
rate on a specified future date or during a specified period. The prefixed rate
is known as the strike price. The specified time is known as expiry date.
Options are divided into two types according to their mode of
settlement. An American type option can be exercised any time before the
expiry date. European type option can be exercised only on the expiry date.
In India we use only European type of options.
A currency option gives the holder option to buy or sell a currency at
strike price on expiry date. Put option is a right to sell the currency at strike
price, and call option is a right to purchase the currency at strike price, the
options being exercisable on their expiry date. A Dollar put / JPY call option,
for USD 1 million with strike price at 80.00 and expiry after 3 months, gives
the holder right to sell USD or purchase JPY, at the rate of 80.00 Yen per
dollar, on expiry date. If on expiry date market rate is 85, the option-holder
will not exercise put option, as he can get more yen per dollar in the open
market. If the exchange rate on the expiry date is 77.00, the option buyer
will definitely exercise the option on the expiry date, as the strike price is
better than market price. In the latter case, the option will be net settled,
i.e., the counter-party pays the holder 3 yen per dollar, or 3 mn yen, being the
difference between strike price and spot rate.
The amount of currency that may be bought or sold under an option
contract is known as notional amount (USD 1 mn in the above illustration).
An option is always net settled the difference between the strike price and
market price of the currency, as applied to the notional amount is received
from the counter party.
The option is known to be at-the-money (ATM) if the strike price is
same as the spot price of the currency. In the context of European option,
47
the spot rate is the rate prevailing on the maturity date, hence it is actually
forward rate as on the date of buying the option. The option is at-the-money,
therefore, when the strike price is same as forward rate on the start date.
The option is in-the-money (ITM), if the strike price is less than the forward
rate in case of a call option, or, if the strike price is more than forward rate
in case of a put option. The option is out-of-money (OTM), if the strike price
is more than the forward rate in case of a call option, or, if the strike price is
less than forward rate in case of a put option. To put simply, ITM is when the
strike price is better than the market price, and OTM is when the strike price
is worse than the market price.
Premium is the price of an option payable upfront. Option premium has
two components. Intrinsic value of an ITM option is the difference between
the strike price and current forward rate of the currency, or zero whichever is
less. Intrinsic value cannot be negative. The ATM and OTM options do not have
any intrinsic value. The option price less the intrinsic value is time value of the
option. The time value is maximum for an ATM option, and decreases with the
option becoming more and more ITM or OTM, as the expiry date approaches.
Some of the important features of options are:
The buyer of an option has the right (but no obligation) to exercise the
option at strike price, irrespective of market price prevailing on the expiry
date. Hence his profit potential is unlimited. The seller of the option
is obliged to buy/sell to the holder of the option at the strike price,
irrespective of market price; the option-sellers potential loss is therefore
unlimited.
The option is based on an amount which is only notional, as only
difference in rates is exchanged in net settlement. The price of an option
is much smaller than the notional value; the traders and speculators
therefore do not require large investments to trade in options (known as
high leverage)
The buyer of an option pays premium to the seller for purchase of
the option. Option premium is the price of the option, payable to the
option-seller upfront. The premium depends on the volatility of the
underlying market, the expiry date (maturity), interest rates and the
strike price the factors that determine the risk to the seller. Option
premium increases with the volatility of the markets, maturity and
intrinsic value of the option.
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Option premium or the price of option is higher or lower based on
intrinsic value and time value of the option. In the money options are
costlier than out-of-the money options. Time value is linked to residual
maturity longer the maturity, costlier is the option.
The option always has two legs. A put option on USD at USD/JPY strike
(right to sell USD against JPY at rate X) is also a call option on JPY (right
to buy JPY against USD payment at X rate). The option may thus be
described as USD put or Yen call at, say, 80.00.
In financial markets, the underlying product may relate to currency,
bonds or equity. A call option on a bond gives right to buy the bond at
a prefixed price (strike price). Since the price of a risk-free bond reflects
the prevailing interest rate, the bond option also becomes an interest
rate option just as currency option is in effect, an exchange rate option.
Likewise, an equity option may have as its underlying exposure, the price
of equity shares of a company, or a stock index (e.g. NIFTY).
An option without any conditionalities is called plain vanilla option, which
is ideal for hedging. However, there are various combinations of options
(option products), which effectively reduce the premium by sacrificing
some upside benefit, or by adding an element of market risk acceptable
to the holder.
There are complex structured products making use of different types of
options, often combining with other derivatives, and covering different markets
simultaneously, to suit requirements of some customers. Such products, often
called exotics as they bundle together different risks, are highly risky and are
generally not suitable for hedging market risk.
As a hedge, currency options are similar to forward contracts. While
exchange risk is protected in both cases, there are material differences between
options and forwards:
Forward Contract Option Contract
The contract must be executed at
contracted rate on the expiry date
The holder has a right to execute the
contract , but has no obligation
The rate is fixed at current
market quote
Holder may choose any strike price
(contracted rate) that suits his
requirement
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Apart from hedging, the options are also used in structuring credit
products. A 5-year bond may be issued with 3-year put option which means
the investor has the option to sell back the bond at the end of 3rd year to the
issuer and redeem his investment, before final maturity of the bond. A bond
with call option gives the issuer similar right to prepay the debt on the specified
date. A convertible option may give the bond-holder option of converting the
debt into equity on specified terms. Such options are called embedded options
and have a direct effect on pricing of the bond.
3. Swaps
A swap is essentially a combination of two forward contracts, involving
a buyer and seller, resulting in an exchange of cashflow of a financial product,
usually currency, interest or a security.
A swap can be a funding swap or a currency swap. Treasury undertakes
funding swaps, as explained in the earlier sections, to bridge short-term funding
Forward Contract Option Contract
There is no fee payable, the
quoted rate includes bank margin
Option premium is payable upfront
Forward premium is the interest
rate differential of the two
currencies involved
Option premium is determined by
several factors, including strike price,
volatility of exchange rates and interest
rates
Forward contract is a simple
contract for purchase or sale of
currency there are no variations
Various types of options are available,
and simple to complex structures, with
varying elements of risk, are possible by
combining purchased and written options
Buyers and sellers have only
counter-party risk, and there is
no market risk to either of them,
so long as the market is liquid
(1) The writer of an option (option
seller) has unlimited risk, while the
buyer of an option has full upside
benefit, with no risk in a plain vanilla
option
(2) There is no market risk in plain
vanilla options; however structured
products may expose the holder to
huge risks, which include market risk,
credit risk and operational risks
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gaps, or for deployment in money market, by swapping one currency into
another currency. A currency swap on the other hand is a hedging instrument
for underlying medium and long-term exposures. We will be discussing here
only currency swaps and interest rate swaps.
Currency Swap
A Currency Swap is an exchange of cash flow in one currency, with that
of another currency. The cash flow may relate to repayment of principal and /
or interest under a loan obligation where the lender or the borrower intends
to eliminate currency risk. If only currency is hedged, it will be P-only swap; if
only interest rate is hedge, it would be I-only swap. It is left to the discretion
of the client to hedge currency and interest rate risks together, or separately.
The need for a swap arises when there is a currency mismatch. For
instance, if a loan is denominated in a currency different from the currency in
which revenue is accruing, there is a currency mismatch. Assume that an Indian
company has raised an ECB of $ 100 mn repayable after 5 years. The loan is
meant to fund an expansion project, hence is converted into Rupees at, say,
45.00 as soon as it is drawn. The risk is depreciation of Rupee at the time of
repayment, say, if the USD/INR exchange rate moves to 50.00, the cost of loan
would increase by 20%, inflating the project cost correspondingly. A currency
swap protects the exchange rate at a desired level, say, at current spot of
45.00, with swap cost payable at, say, 4% p.a.
Operationally the three variants of currency swap function as under:
Principal only swap: Using the above illustration, the borrower continues
to pay interest in USD terms, but has the benefit of using the principal
amount in home currency, without exchange risk. The repayment takes
place in domestic currency, at a fixed rate of exchange, hence there is no
exchange risk.
Interest only swap, or Coupon Swap: The currency risk is left open, but
interest on USD loan is swapped into Rupee interest the borrower pays
interest in Rupees at swap rate on the notional Rupee amount equivalent
of USD loan; principal repayment is as per original loan terms.
P+I swap: Without initial exchange where the borrower has eliminated
the currency risk and interest rate risk completely (zero risk) and will pay
principal and interest in domestic currency (Rupees) at fixed rates to settle
the foreign currency borrowing. The swap cost is included in the rupee
interest rate.
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If we look closely, we find that the currency swap only combines the
currency forward rates and forward interest rates (FRAs as under IRS, please see
below) for the relevant period, in a structure easily understood by the buyer
of the swap.
Interest Rate Swaps (IRS)
A swap is an exchange of cash flow. An interest rate swap is an exchange
of interest flows on an underlying asset or liability, the value of which is the
notional amount of the swap. In a swap, basis for calculation of interest is
changed according to the requirement of the borrower (or, lender).
An interest rate swap is shifting of basis of interest rate calculation,
from fixed rate to floating rate, floating rate to fixed rate or floating rate to
floating rate (the latter based on a different benchmark rates). The cash flows
representing the interest payments during the swap period are exchanged
accordingly.
To illustrate, assume a company has borrowed USD 10 mn at floating
rate of 3-month LIBOR + 2% p.a. The company would not like to retain the
LIBOR risk, and enters into a interest rate, fixing the interest at 4% p.a for
next 5 years, covering the loan period. Under the IRS, the company receives
from the counterparty bank 3M-LIBOR (to set off interest payments on the
underlying loan) and pays the counterparty fixed rate of 4% p.a, quarterly,
irrespective of rise or fall in the LIBOR. The interest amount is calculated on a
notional amount, which in this case is equal to loan amount of USD 10 mn. In
practice, the company receives or pays the counterparty bank, the difference
in 3M LIBOR and the agreed fixed rate, as applied to the notional amount, on
every payment day (at quarter-end).
Conventionally, the fixed ratepayer is known as the buyer of swap and
the fixed rate receiver is the seller of the swap.
The floating rate of interest is always linked to a benchmark rate. A
benchmark rate is a risk free interest rate determined by the market, and
is widely accepted by market players for its objectivity and transparency.
The issuers of debt paper and the lending banks link the interest rate to a
benchmark rate acceptable to investors/borrowers, so that the actual interest
paid by them reflect the market trends. Benchmarks commonly used are LIBOR
for USD and O/N MIBOR and G-sec rates for Rupee.
A floating to floating rate swap (also known as basis swap) involves
change of benchmark rate. If a company, having opted for a T-bill linked
52
rate, later prefers to have a base rate of MIBOR, they can enter into a swap
whereby they receive T-bill rate and pay MIBOR linked equivalent rate.
Interest Rate Swap (IRS) is a OTC instrument normally issued by an
authorised bank. There is a variety of interest rate swaps and swap structures,
which are explained in later sections.
A product closely linked with IRS is forward rate agreement (FRA),
where the interest payable for a future period is committed under the
agreement. While IRS covers a series of periodical interest payments, FRA is for
a single payment in future. If a loan carries interest rate linked to LIBOR, and
the interest for next half year is due to be fixed on 29th December we run a
risk that the LIBOR in December may be much higher than todays LIBOR. We
would hence like to fix the interest rate for 29th December now, say on 29th
June, based on current LIBOR. For this purpose, we buy a 6/12 FRA (i.e. to
fix interest rate 6 months hence, for the next 6-month period), say at 2% p.a.
Exchange Traded Derivatives: Currency and Interest Rate Futures
Exchange traded currency derivatives is an important segment of
derivatives market. While OTC market is confined to end-users (hedgers)
and market makers in inter-bank market, the participants include hedgers,
arbitrageurs as well as speculators, as there are no restrictions on currency
trading in futures market in India.
Currency futures, currency options and interest rate options are traded
in Indian exchanges with settlement in Rupees. Currency futures in four major
currencies are traded in National Stock Exchange, MCX-SX and United Stock
Exchange, while USD/INR options and Interest Rate Futures are traded only
on NSE. The market for Interest Rate Futures, however, has not been active.
The futures market is described more fully later in the supplement to
Part 6.
mmm
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Derivatives 2
Option Pricing
The price of an option is known as premium which is payable upfront,
at the time of purchase of the option.
The premium for a currency option is determined by multiple factors
impacting the movement of the underlying exchange rates.
There are several quantitative models to derive the price of an option,
the most important and most popular model being that of Black Sholes. Black
Sholes Option Pricing Model is widely used for pricing currency and stock
options. There are also other pricing models like Binomial Option Pricing
System and Monte Carlo simulations, which are some-times used for pricing
structured products like barrier options, and interest rate derivatives. The
models are readily available on computers, for pricing any type of options. (Brief
explanation of BSOP model is given in the Annexure 1)
We would however focus on use of currency derivatives for hedging,
rather than on the quantitative methods of pricing. The elements that go into
the pricing of an option in the BSOP model are:
Spot exchange rate spot rate as at the time of the option deal is
important, as variation of the exchange rate in either direction is measured
from the spot rate.
Strike price the exchange rate at which the buyer of the option has
a right to buy or sell a currency. An ITM (in-the-money) options is costlier
than an OTM (out-of-the-money) option. The intrinsic value of the option is a
component of the option price.
Interest rates the risk-free interest rates of the currencies being
exchanged. The interest rate differential is also expressed as the forward
premium or discount on the currency being bought or sold.
Volatility of the exchange rate Volatility is a measure variability of
exchange rate over a period of time. In simplest terms, volatility is the standard
deviation of exchange rates from the mean during an observation period
5
CHAPTER
54
actually, the deviation is measured in terms of relative price changes, rather
than the price (exchange rate) in absolute terms. Volatility is either historic,
derived from past data, or implied, based on the traded prices of the option.
Volatility is the risk in forecasting future rate movements, and higher the
volatility, higher is the price of an option. Volatility is the lowest for an ATM
(at-the-money) option.
Time to expiration the tenor of the option, i.e. the period from spot
date to expiry date of the option determines the time value of an option. Time
value is highest for an ATM option.
Option price changes in response to any small changes in the underlying
parameters described above. Measures of sensitivity to change are known as
greeks (Greek alphabet), the most important of them being delta. Delta is the
change in the value of the option (option premium) for a given change in the
underlying exchange rate. The delta impacts the cost of option and is a tool for
the option writer to hedge the risk in the option. For instance an option writer,
selling a USD call option with a delta of 0.25, can hedge his risk by physically
buying 25% of the notional amount the exchange gain/loss on the USD held
will compensate the loss/ gain in the value of the option. Delta is also known
as hedge ratio.
Some of the Greeks which are commonly used in pricing options /
hedging option risk, are defined in the annexure.
Use of options
Options, like any other financial derivatives, are used by
Hedgers, who have underlying transactions or assets exposed to market
risk, use options to reduce or cancel the currency and interest rate risks
Arbitrageurs, who derive benefit from fleeting differences in currency
and interest rates, due to either locational or time-zone differences, before
equilibrium is restored in the markets (by competitive forces), and
Speculators, who trade for profit in currencies and derivative products,
also include market makers
It is to be understood that hedgers protect the underlying risks (fully or
partly), arbitrageurs engage in almost risk-free operations (buying and selling
simultaneously), while the speculators are fully open to market risk.
55
Combination of options
A plain vanilla option is an unconditional right to buy or sell a currency
9 or any underlying asset).
A buyer of plain vanilla option has to pay a premium upfront, as price
of the option.
A holder of plain vanilla option has no down side risk (in case of adverse
movement of exchange rates) and has unlimited upside benefit (if exchange
rates move favourably). His loss is limited to the premium paid upfront (similar
to insurance premium).
The writer of an option the option seller, has unlimited risk (if markets
move adversely), his only gain being the premium earned for the sale of the
option.
A combination of options, or an option structure is some-times used to
hedge market risk, in order to reduce the cost of the option, by absorbing part
of the risk and/or limiting the upside benefit.
The above objective is achieved by combining two or more of the
options, which include purchased options (buy put or buy call) and written
options (sell put or sell call). The premium received on written option(s) goes
to reduce the premium payable on the purchased option(s). When the premium
on the purchased option(s) is fully off-set by the premium received on the
written option(s), the option structure is called a zero cost option.
An option structure in order to qualify as hedging instrument, must satisfy the
following conditions:
Net premium for the option structure should not be positive premium
receivable on the written options should not be higher than the premium
payable on the purchased options.
The notional amount of the written options should not be higher than that
of the purchased options, and
All the legs of the option structure should have identical expiry date.
There are several kinds of option structures in OTC market, which can
be customized to the requirements of a business entity. Some of the common
structures in use are briefly described below.
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1) FX Range Forward
A Range Forward is where the company enters into a collar (buy one
option and sell another for the same notional amount simultaneously) in order
to reduce the cost of option, or to make it zero cost. To illustrate:
An importer in India may buy the following structure for USD payment
due after 6 months:
Buy call on USD for $ 1,000,000 @ 47.60 due on 31 January, 2012
(right to buy USD at strike price)
Sell put on USD for $ 1,000,000 @ 46.60 due on 31 January, 2012
(obligation to buy USD at strike price)
The buyer has a right to buy the USD at 47.60 so long as the Rupee
does not appreciate to or above 46.60 as on the expiry date. In case of Rupee
depreciation, the importer is fully protected at 47.60, but in case of Rupee
appreciation, his benefit is limited to 46.60 i.e. the importer has sacrificed his
upside profit beyond the level of 46.60. There is an opportunity cost in case
the Rupee rises to say, 45.00 as on 31 January, 2012, as the importer is obliged
to buy USD at the strike rate of 46.60 only.
The premium receivable on the sell leg fully offsets the premium
payable on the buy leg hence it is a zero cost option.
2) Participating Forward Option
This option is similar to range forward, except that the notional amount
sold or purchased under the second leg is less than the amount under the
first (buy) leg. The import exposure in the above illustration may be hedged
as under:
Sell put on USD for $ 500,000 @ 46.00 due on 31 January, 2012
Premium payable: ` 398,798 or annualized cost 1.78% p.a.
In this structure, the cost of import is protected at 46.50 in case of
Rupee depreciation, but if Rupee appreciates beyond 46.00, the importer will
get a better rate for half the notional amount ($ 50,000), while for the balance
half, upside is limited to 46.00. Hence the sacrifice of upside benefit is less in
participating forward, as compared to range forward option.
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The premium received on second leg will reduce the premium payable
on the first leg. Net premium payable, however, is still less than the premium
payable on plain vanilla option (Buy call on USD @ 46.50), which works out to
` 12,00,000 or 5.16% p.a., almost 3 times the cost of structure quoted above.
The notional amount of second leg will be less than that of the first leg,
but the ratio may be set as appropriate to the importer. For export exposure,
the strike rate of second leg will be higher than that of the first leg, similarly
limiting the upside for part of the notional.
It is not possible to have a zero cost structure for participating forwards.
3) Put/Call Spread
Put spread or call spread is achieved by buying and selling the same
option for same notional amount and same expiry at different strike prices. For
instance, an exporter may opt for the following put spread:
Buy put on USD for $1,000,000 @ 46.50 expiry 31 January, 2012
Sell put on USD for $1,000,000 @ 44.50 expiry 31 January, 2012
Premium payable: ` 727,237 or annualized cost 3.15% p.a.
The exporter has the right to sell USD at 46.50 or at market price
whichever is better, and thus has full benefit on upside movement of the
exchange rate (on depreciation of Rupee). However, if Rupee appreciates
to 44.50 and beyond, he can sell USD at ` 2.00 better than market rate
better by the difference between the two strikes in the above structure (if
spot on expiry is 48.00, he can sell at market rate, without exercising the
option; however, if Rupee appreciates to, say 44.00 levels, he can only sell at
44.00+2.00=46.00). Even though the protection offered to the exporter is thus
limited on the downside, the exporter always gets better than spot in case of
appreciation of Rupee.
Premium payable is higher, but still lower by about 40% as compared to
plain vanilla put at 46.50.
An importer may similarly opt for a call spread (buy call & sell call)
where the strike for second leg will be higher than that of the first leg.
4) Seagull Structures
In put spread and call spread structures described above, the upside
benefit is unlimited, similar to a plain vanilla option. A seagull structure reduces
58
the option premium further, by capping the upside benefit. For this purpose,
the seagull structure adds one more leg to the put or call spreads.
An exporter may reduce the net premium to nil (zero cost), by using a
sea gull structure as under:
Buy put on USD for $ 1,000,000 @ 46.50 expiry 31 January, 2012
Sell put on USD for $ 1,000,000 @ 44.50 expiry 31 January, 2012
Sell call on USD for $ 1,000,000 @ 47.50 expiry 31 January, 2012
Net premium payable: Nil
If Rupee depreciates, the upside benefit is limited to 47.50 reaching
which the exporter will be obliged to sell at strike rate 47.50. In case Rupee
appreciates to 44.50 and above, the exporter will be able to sell at better
than market rate (by ` 2) better by the difference between buy put/sell put
strikes.
Any number of option structures are possible, depending on the
requirement of the business entity. The considerations in selecting an option
structure should be:
The pricing of the option should be transparent, with market determined
in-puts.
The option product must have a liquid market, with easy exit route.
The worst case rate under the option must be well defined.
The option terms should be clearly mentioned; market practices with
regard to day count, holiday convention and settlement channels should
be followed, and where they are not universal, should be clearly spelt out.
The option must satisfy local regulatory requirements, particularly in cross-
border deals. For instance, a cost reduction structure perfectly valid in
Singapore market, can be offered in India, only if the hedger is eligible to
use such options under RBI regulations.
The option must also comply with accounting requirements it should be
a qualified hedging instrument under IFR, otherwise the option may result
in accounting losses.
Most of the combinations of plain vanilla options would satisfy the above
conditions, provided the option is an appropriate hedge for the underlying
exposure and is suitable to the risk appetite of the user.
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Exotic Options
There are also exotic options with complex structure, which are high
risk and are speculative.
Exotic options are combination of options with multiple conditions
attached, where the protection offered does not reflect the underlying risks
entirely. Exotic options come under various types, such as barrier options,
Bermuda options, leveraged options and digitals. Often, banks structure such
options to cater to the requirement of specific clients who would like to take
aggressive positions, based on their market view.
For instance a plain vanilla option with a knock-in (k/i), or a knock-out
(k/o), or both limits can be termed as an exotic. A k/i limit is the market rate
at which the option comes into existence, and a k/o limit is the market rate
at which the option ceases to exist. An option structure may have multiple
barriers for each of its legs.
At times the underlying market for an exotic option may have little to do
with the risks covered. An option structure may offer protection for, say, sale
of USD at a given strike rate, only when the 1-5 year treasury yield spreads
(difference between yields on 1 year and 5 year Notes of US treasury) become
negative. Similarly, a digital one time option my simply offer to pay the holder
a given sum, say, $ 500,000, if Euro/USD touches, say, 1.25 on a given date,
or within a given period.
Exotic options are not defined precisely, and it is often subjective
judgment to classify an option as exotic. The exotic options generally differ
from regular option structures in the following respects:
The pricing of exotic options is often not transparent and most such
options are priced on proprietary models of global banks/specialized
investment institutions
For the above reason there is no liquid market, hence exit from an option
structure depends on the MTM price offered by the writer of the option.
There is a disconnect between the underlying risk and protection
offered. Often the exotic option becomes an independent position in the
derivatives market, with its own market risk.
The exotic options heavily rely on market view or on past trends, hence
it is seldom possible to define worst-case loss. Allocation of risk capital
serves no purpose, as losses under exotic options can be unlimited.
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Exotic options like barrier options and leveraged options are not
permitted by Reserve Bank of India. Under IFRS accounting standards, exotic
options do not qualify as hedge instruments, but can be dealt with by a
business entity as trading positions (financial instruments measured at fair value
through P&L account).
Interest Rate Swaps (IRS)
Financial derivatives are broadly divided into currency and interest rate
derivatives. Within each group we have forward and option products.
Interest rate swaps are interest rate derivatives under forward products
group, extensively used to mitigate interest rate risk, as part of liability
management. Swap is an exchange of future cashflows, and each cashflow is a
typical forward contract. An interest rate swap consisting of a single cashflow
therefore is called a forward rate agreement (FRA). The interest rate swap is
a series of FRAs, to cover interest rate risk in medium and long-term liabilities.
Just as in case of forward contracts, IRS must be settled on due dates,
and entails an opportunity cost in that the interest rate fixed under the swap
will be binding irrespective of market rates as on settlement date.
The distinction between currency and interest rate swaps is made only
for conceptual clarity. They are overlapping in protection of market risk in FC
borrowing in two ways:
Cross currency swaps where currency and interest rates are swapped,
e.g. USD loan swapped into Rupee loan and USD floating rate of interest
swapped into Rupee fixed rate of interest a single annualised swap
premium covers cost of both.
Cross currency interest rate swap, where interest rate in one currency is
swapped into another currency includes exchange rate protection for
amount of interest payable.
As a consequence, cross currency swap valuations include forward
interest rates (FRAs), as also forward exchange rates.
There are several types of interest rate swaps prevalent. The commonly
referred types are:
Coupon Only Swap (COS) refers to swapping floating rate of
interest to fixed rate, or vice versa, in the same currency or in different
currencies, the latter is same as I-only currency swap
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Basis Swaps refer to swapping one floating rate to another floating
rate e.g. LIBOR linked rate to T-bill linked rate
Overnight Interest Rate swap (OIS): In OIS, overnight interbank
rate (e.g. Mumbai Inter Bank Offered Rate, or Fed Rate in US) is swapped
against a floating rate (e.g. 1-year G-sec Rate) or a fixed rate of interest. The
overnight interest rate is expected to be settled daily; however, in practice the
overnight rate is compounded daily and net interest flows are exchanged on
agreed settlement date, quarterly or half yearly. Interbank market (also referred
to as call-money market) being highly liquid, OIS with overnight MIBOR as
benchmark rate has evolved as most popular swap in India. OIS however, is
largely based on view of yield curve shifts, and may not always correspond to
underlying risks of a business entity.
Total Returns Swap the swap protects interest rate risk as well as
credit quality of a debt paper, by returning fixed rate of interest and capital
invested. The value of an investment changes with change in market yield, and
change in credit status of the issuers both risks are protected under the total
returns swap (e.g. swapping a corporate debt paper with interest at 5-year
G-sec+2%, for a 7% - principal protected investment)
Constant Maturity Swaps (CMS) CMS is a popular hedging
instrument with investment managers who would like to hedge the duration
risk of their portfolio. CMS swaps a swap rate (generally based on a risk free
yield curve) for a floating rate linked to money market (e.g. LIBOR) or for a
fixed rate for the corresponding period. CMS, where a swap rate is replaced
with yield on a risk-free security, is referred to as constant maturity treasury
or CMT swap, which is popular in India. To illustrate, the coupon on a 10-year
G-sec is exchanged against a fixed rate of, say, 8%. The benchmark security for
10-year G-sec is always changing, and on each reset date, the yield for next 10-
year period is to be calculated on the basis of market price of current bench
mark security. Or it may also be based on a security index. CMS can be single
currency or cross-currency swaps. The pricing of a CMS is more complex than
that of a plain vanilla interest rate swap, as it involves implied yield curve shifts
and convexity adjustment.
Quanto Swaps Domestic interest rate on a loan is exchanged with
interest rate in a foreign currency, without involving currency conversion
e.g. 8% on Rupee loan exchanged with USD 3-month LIBOR+4%,
where the buyer of the swap pays nominal equivalent of 3M L+4% (say,
0.50%+4%=4.5%) and receives fixed interest at 8% from the counter-party
62
bank, on the notional amount of Rupee loan. (quantos are not permitted in
India)
Pricing & Valuation of Swaps
A currency swap is priced at inception, involving the following steps:
Consider each cashflow as a forward contract for the given due date and
arrive at the forward sale or purchase rate if a USD loan is swapped
into Rupee loan, the borrower company buys USD forward for each
installment payable, from the counter-party bank.
The cashflows are mapped with due dates, USD receipts on one side,
converted into Rupees at applicable forward rate, and corresponding
Rupee payments on the other side.
The Rupee cashflows on both sides are discounted with corresponding risk
free interest rates, to yield their present value.
Find out by trial and error (or, apply goal seek in excel worksheet) a rate
of interest to be applied on Rupee payments, that will make the PV on
both sides equal.
The interest rate at which the net present value of the cashflows becomes
zero, is the annualized swap premium, or the cost of the swap
During the course of the swap, at any point of time, the swapped
cashflows for residual period of swap can be valued likewise, at the given swap
rate. That is, the valuation is done not to find out current swap rate at par, but
to find the value of swap applying the swap rate already fixed, to the cash out
flows, and converting the USD cash inflows at current forward rates. As a result,
the NPV of the discounted cashflows will not be zero, but it will be a positive
or negative figure. The NPV is the mark-to-market (MTM) value of the swap.
An interest rate swap is also priced similarly, with the difference that FRA
rates would replace the forward contract rate for determining the cash inflows
and cash outflows. A floating to fixed interest rate swap may be viewed as a
net interest flows from simultaneously issuing a bond with floating rate and
investing in a bond with fixed rate of interest. The floating rate for each of the
cashflow is a FRA rate, described below.
Pricing of a FRA (forward rate agreement): As discussed earlier, FRA
is fixed interest rate equivalent of floating rate for a single payment in future. If
63
a loan carries interest rate linked to LIBOR, and the interest for next half year
is due to be fixed after 3 months, say on 30 December, 2011, we run a risk
that the LIBOR as at the end of December may be much higher than todays
LIBOR. We would hence like to fix the interest rate as on 30 December for
half-year period commencing from 1 January 2012 now, based on todays rate.
For this purpose, we need to buy a 3/9 FRA (i.e., to fix interest rate 3 months
hence, for the next 6-month period).
FRA is simple arithmetic based on term structure of interest rates. To
find 3/9 FRA,
Check interest rates for 3 month deposit and 9 month deposit as on date.
Assume USD LIBOR for 3 months is 0.5% p.a. and for 9 months it is
1.25% p.a.
Assume you are depositing USD 1000 for 3 months at 0.5% - the deposit
proceeds at the end of 3 months will be $ 1000.25
If the same amount is deposited today for 9 months, the deposit proceeds
will be $1009.25
Find out at what rate of interest, if the 3-month deposit proceeds are
rolled over for next 6 months, the proceeds at the end of renewed period
will be equal to 9-month deposit proceeds or, at what rate of interest,
$1000.25 renewed for next 6 months will yield $ 1009.25? The answer is
1.85% p.a..
The 3/9 FRA fixes the interest rate for next payment period commencing
from 1 January 2012, at 1.85% p.a. , equal to the agreed floating rate of 3
M LIBOR as on the reset date. The FRA function is available in the excel
worksheet.
It is normal practice that the floating rate (e.g. LIBOR) for a interest rate
payment period is decided in advance, on the last day of the previous period/or
one day before last day, as in the case of LIBOR, but interest is paid at the end
of the interest payment period. In case of FRA, the market convention is, the
interest settlement takes place at the beginning of the period (on 1st January
2012 in the above illustration). The interest is duly discounted for the period,
and hence the effective rate remains same.
In practice, the FRA rates are extracted from a risk free yield curve, or
in a liquid market, from the swap curve. The latter comprises of swap rates
64
quoted by market makers for different swap periods. The difference between
risk-free yield curve (e.g. 5-year G-sec yield) and the swap curve (e.g. swap
rate for 5 years) is that the latter incorporates bank risk (credit risk) and
liquidity risk (supply-demand effect) in to the former.
Coming back to the pricing of interest rate swap, the swap is an
exchange of cashflows corresponding to underlying interest payments. If a
business entity swaps floating rate of interest (say, 3M LIBOR) on a USD loan,
to a fixed rate, the cashflows for the business entity are,
a) Receive interest at floating rate from the counter-party bank, and
b) Pay interest to the counter-party bank at fixed rate
thus, transferring the floating rate risk to the counter party bank. To find out
the fixed rate of interest:
Apply FRA rates to project each of the cash inflows under (a) above
Map corresponding outflows under (b) above applying an assumed fixed
rate to all cash outflows
Discount cash inflows and cash outflows at risk free interest rates, to
arrive at PV of (a) and (b)
Find out by trial and error (or, apply goal seek in excel worksheet) fixed
rate of interest that will make the PV on both sides equal.
The interest rate at which the net present value of the cashflows becomes
zero, is the swapped rate of interest equal to the contracted floating rate
of interest
To value the swap during the course of the IRS, at any point of time,
in the above set of cashflows, replace the FRAs for inflows, with current FRA
rates, leaving the corresponding fixed rate outflows unchanged for residual
period. Discount the cashflows at current risk free interest rates. The resultant
positive or negative NPV is the mark-to-market value (MTM) of the swap.
MTM value of the swap is the value the business entity has to receive
or pay (to the counter-party bank) upon termination of the swap, before the
final expiry of the swap.
The IRS illustrated above is for swapping floating to fixed rate of interest
in a single currency (say, to pay fixed rate on USD loan). For cross currency
65
swaps (e.g. USD interest swapped in to Rupee interest), the cash inflows in
foreign currency (USD) are converted in to Rupees at current forward rate,
before discounting, and the cash outflows at assumed fixed rate are calculated
on notional rupee equivalent of the USD loan at current spot rate. Rest of the
procedure remains the same. (Refer annexure 2 for illustration)
Interest Rate Derivatives: Option Products
The most common OTC option products for protection of floating rate
risk are caps and floors.
A cap is an interest rate option, whereby the buyer of the option will
receive for each period in which the reset benchmark rate exceeds the strike
rate, an amount equivalent to difference between floating rate and strike rate.
If a 3M LIBOR cap is bought at 2.5% for a period of 2 years, the LIBOR
is reset for each 3-month period, and in case the reset LIBOR exceeds 2.5%,
the excess of floating rate over LIBOR is received by the buyer from the
counterparty. If the LIBOR rises to say, 3%, the counterparty bank pays to the
buyer of the cap 0.5% (= 3%-2.5%) for the 3-month period. Thus the cap
strike rate is the maximum LIBOR payable by a borrower on a USD loan.
A floor is a similar interest rate product, whereby the buyer of the
floor will receive a payment for each period in which the reset benchmark falls
below the strike rate, equivalent to difference between strike rate and floating
rate of interest.
If a 3M LIBOR floor is bought at 0.5% for a period of 2 years, the
LIBOR is reset for each 3-month period, and in case the reset LIBOR is lower
than 0.5%, the excess of strike rate over the LIBOR is received by the buyer
from the counterparty. If the LIBOR falls to 0.30%, the counterparty bank
pays to the buyer of the floor 0.20% (= 0.50%-0.30%) for the 3-month
period. Thus the floor protects the minimum interest rate received by a lender,
eliminating the floating rate risk.
The cap sets the maximum LIBOR payable by a borrower on a USD
loan, while the put sets the minimum LIBOR receivable by the USD lender,
irrespective of LIBOR fluctuations. (caps & floors work similarly for floating rate
in any currency, if there is a liquid options market.) Being option products, the
buyer of a cap or floor needs to pay the option premium upfront.
A business entity having FC liability (say, USD loan) can opt for a collar,
in order to reduce cost of an option for interest rate protection. A collar is a
66
combination of cap and floor. The borrower with interest rate linked to 3M-
LIBOR, may buy a cap on LIBOR (say, at 2.5%) and sell a floor on LIBOR (say,
at 0.5%). The premium received on sale of floor offsets the premium payable
on the cap, in full or in part.
The pay-off of the collar in the above context is the borrower
pays interest at 2.5%, if LIBOR is higher than 2.5%,
pays interest at LIBOR if the reset rate is lower than the cap (2.5%), but
higher than the floor (0.5%), and
pays interest at 0.5% if the LIBOR is below 0.5%.
Thus the collar fixes the maximum and minimum interest rate liability of
the borrower, as a hedge against the floating rate risk.
The pricing of caps and floors follow the Black-Sholes option pricing
model. A cap protects the rate of interest for each of the interest payment
periods over the redemption period of the loan (e.g. 8 interest payment
periods for a loan repayable over two years, at interest rate linked to 3M
LIBOR with quarterly settlements). The cap for each period individually is
called a caplet, hence the cap is a series of caplets and each caplet is priced
as an option, the cap being the strike rate. Similarly the floor is also a series
of floorlets.
Similar to combination of currency options, there are any number of
structures that include purchase/sale of caps and floors.
There are also exotic interest rate derivative structures, variously
described as range accruals, target redemption swaps, inverse floaters and
swaptions. The exotic products do not have a liquid market and the pricing is
based on proprietary models of the issuer. Most such products are not qualified
as hedging instruments.
Use of Derivatives in Risk Management
As stated earlier, market risk arises owing to cashflow mismatches.
Currency mismatches result in exchange rate risk, and maturity mismatches
result in interest rate risk.
Derivatives help eliminate or minimize the currency and interest rate
risks, by transferring the risks to a counterparty in full or part.
For a business entity, the choice of a derivative instrument depends on
67
The cost of hedging (premium payable in case of options and opportunity
cost in case of forwards)
The efficacy of the derivative (the pay-off in adverse market conditions),
and
Its ability to absorb residual risk (while using structured products which
may offer only partial protection)
Use of Forward Contracts
Forward contract is the most commonly used instrument for protection
from exchange rate risk, the reasons being that
There is no upfront cost the premium or discount is part of the
exchange rate to be applied to the underlying exposure
The contract terms are easily understood there are no variations from
the standard contract, and
Forward rates are quoted in the market facilitating easy entry and exit
from the contract.
The forward contract offers a fixed rate of exchange which would help
the business entity forecast its future revenues more accurately.
As discussed earlier, forward contract implies purchase or sale of a
currency at spot rate, with exchange of interest rate differential for the delivery
period. The forward contract hence eliminates the exchange risk completely.
For this reason use of forward contract is often described as zero risk strategy.
An oft ignored merit of forward contract is its utility when the
cashflows are of uncertain maturity. A business entity would not usually be
able to forecast the cashflows export realizations and payment for imports
accurately, as there could be unforeseen delays owing to delay in shipment or
delay in processing of documents. As a result, the payment/realization of bills
may take place earlier to or later than the expiry date of the contract. In such
cases the forward contract can be pre-utilised or rolled over to synchronize
with the revised due date.
Pre-utilisation amounts to cancellation of the forward contract before the
due date, in case of an early payment. Roll-over amounts to cancellation and
rebooking of the forward contract for the extended due date. In either case,
68
the difference in premiums (for original expiry period and revised period) is
either received or paid to the counterparty bank. The underlying exchange rate,
shorn of the interest element, effectively remains unchanged.
We may therefore say that in case of preutilisation or rollover, protection
of exchange rate under forward contract continues to be valid, except for
settlement of difference in the premiums. Normally risk with premium rates
(interest rates) is much less significant than the exchange rate risk. Forward
contract therefore is an appropriate hedge instrument in the context of
uncertain cashflows, partly replacing the exchange rate risk with interest rate
risk.
Forward contracts however, suffer from the disadvantage that the
contract offers a fixed rate for a future date, and there is no way that the
holder can benefit from better rates in the market on the expiry day. He
cannot also lock into a rate of his choice, as the forward rates are market
determined. Some people may not even consider forward as a hedge, as the
forward contract is essentially purchase or sale of currency completed today at
spot rate, with only delivery deferred for a future date.
Use of Option Products
A plain vanilla option is an ideal hedge as it serves the purpose of
assuring a desired rate of exchange, and at the same time allowing the benefit
of better rates in the market as on the expiry date.
The advantage of an option lies in that
A business entity can select the exchange rate which needs to be
protected this is an important feature in the context of a target rate or
budget rate stipulated by the FX Risk Management Policy.
Once premium is paid upfront, the option has only the upside benefit the
MTM value of a plain vanilla option is never negative.
Options market is fairly liquid and pricing is transparent there is hence
no difficulty in exiting from an option contract.
Despite the obvious benefits, the use of options is inhibited by the
upfront cost. The option premium is directly influenced by factors like in-the
money feature of the strike price, time to expiry and the volatility of exchange
rates. The holder of an option also tends to think that the premium paid is an
69
unnecessary expense, if he subsequently finds that the markets in any case have
moved favourably however irrational is the perception.
The option products combination of options or structured products
appeal to the hedgers, by reducing the cost of option, at times to zero, by
retaining a part of the market risk. As discussed earlier, common structures
include range forwards, participating forwards, put/call spreads and seagulls. In
each case, the holder of the structured product, sacrifices some benefit from
the upward movement of exchange rates, and retains in the process a part of
the exchange risk.
A business entity must choose an appropriate option product, after
considering the nature of underlying cashflows, the target rate to be protected
and potential loss in worst possible case. Seemingly innocuous products may
some time result in unpredictable losses. A range forward option is analysed
below to bring out the strengths and weaknesses inherent in the structure.
Please recall the illustration of range forward option in the previous
section.
Sell put on USD for $ 1,000,000 @ 46.60 due on 31 January, 2012
Let us assume that the importer has a target of 47.60 which is fully
protected under the buy leg of the option, in case Rupee depreciates beyond
that level. The second leg limits the benefit of appreciation, by imposing an
obligation on the importer to buy USD if the spot rises to 46.60 level. The
exporter is comfortable as a) his target rate is protected at zero cost and b)
he has potential gain of ` 1 per dollar, if spot reaches 46.60.
Let us further assume that the underlying cashflow for some reason is
cancelled or deferred indefinitely quite possible if the importer is hedging
a forecast cashflow. Let us also assume that Rupee rises to 45.00 as on the
exercise date. The first leg of the option will not be exercised as market rate
is better than the strike rate by ` 2.60. Under the second leg, the importer
has to buy USD notional of 1 mn at 46.60 and sell the USD at market rate of
45.00 (as he no longer needs USD for import payment), thus incurring a loss
of ` 25,00,000.
In the above situation, potential loss cannot be defined as Rupee could
rise to any level. The option structure therefore is not suitable to a business
entity if the FC payments/receipts could not be projected with some degree
of certainty.
70
A put or call spread structure, on the other hand, may or may not
protect benchmark rate, but the realized rate will always be better than spot
rate, and in that sense does not result in cash loss. This structure is particularly
useful in hedging medium and long term risks in foreign currency loans. For
instance, a USD/INR call spread of 45.00 55.00 for a 5 year period, covering
say, half-yearly installment payments, would ensure that the borrower will buy
USD on each payment date,
A. At 45.00, so long as Rupee does not depreciate beyond 55.00
B. At better rate prevailing in the market, if Rupee appreciates above 45.00,
with full upside benefit (similar to plain vanilla call option), and
C. At ` 10 better than spot rate (spot-10.00) if Rupee depreciates beyond
55.00
The merit of a call spread option lies in that the holder has full upside
benefit, and is able to buy at better than spot rate even in adverse market
conditions. The MTM of call option is always positive or nil, but never negative.
The disadvantage of the structure is that in scenario (C) above, the benchmark
rate 45.00 is not protected, and higher the spread, costlier will be the option.
Thus a borrower in foreign currency, may opt for call spreads to protect
the exchange rate risk, if he does not mind losing the benchmark rate, so long
as he makes a profit over the spot rate. The spread is also decided based on
his view of the market. A put spread will work in similar fashion to an investor
/ lender.
There is a variant of range forward options which is of interest to
hedgers who would prefer to have a forward contract, but at a rate of their
choice. A range forward option with the same strike price for both the legs is
known as a par forward or a synthetic forward contract, as it fixes the strike
price as forward rate. To illustrate, assume an exporter hedges as under:
Buy put on USD for $ 1,000,000 @ 47.00 due on 15 December, 2011
Sell call on USD for $ 1,000,000 @ 47.00 due on 15 December, 2011
(premium payable ` 10.68 lakhs)
The pay-off of the structure is exactly like that of a forward contract
the exporter can sell USD 1 mn at 47.00 on the exercise date, irrespective of
the spot rate as on that day. Locking into a forward rate is desirable, if the rate
meets with target set by the Management.
71
A business entity must choose an appropriate option structure, after fully
understanding potential losses in worst case scenario, and should avoid use of
exotic structures for hedging underlying exposures.
Use of Interest Rate Swaps and Options
An interest rate swap (IRS) exchanging floating interest rate in to-
fixed interest rate works like a forward contract with similar advantages and
disadvantages.
The floating rate of interest paid by a business entity is split into two
parts the floating rate benchmark and the credit spread (e.g. 3M LIBOR +
2% p.a.). The credit spread is fixed for the tenor of the loan. Only the floating
rate benchmark is swapped to fixed rate, if the borrower prefers to pay a fixed
rate of interest.
Assume that the 3M LIBOR which is 0.35% today, is swapped into a
fixed rate of 3% per annum for the next 5 years. The borrower will therefore
pay 3% p.a. irrespective of 3M LIBOR prevailing in the market. The borrower
is comfortable paying the fixed rate as he has fully eliminated the risk of LIBOR
rising beyond 3% over the period of loan. The IRS is particularly useful in
project funding, where predetermined costs help more accurate projection of
cashflows.
However the borrower is also foregoing the benefit of lower LIBOR
prevailing in the market. Some borrowers may prefer to have both the benefits,
viz. pay lower LIBOR in the market, and at the same time enjoy protection
against rise of floating rate beyond a specified rate. Interest rate cap, described
earlier, offers such a protection. A cap of 4% ensures that the borrower is fully
protected when LIBOR crosses 4%, till which time he would continue to pay
interest at 3M LIBOR (always lower than 4%) as reset at market level for each
interest payment period.
Interest rate cap is an option product hence involves payment of
premium upfront. The premium is payable in addition to the interest on the
loan, hence cost of the cap may become an inhibiting factor.
For a lender, a floor of LIBOR offers similar protection assuring a
minimum rate of interest in case the LIBOR falls below the floor level, again
with premium payable upfront (a reduction in the interest income).
Collar, a combination of cap and floor, described earlier, is used to
minimize the cost of the option. A borrower may buy the cap and sell the
72
floor, while a lender may buy the floor and sell the cap in each case the sale
of cap or floor generating premium income to off set the premium payable on
the buy leg.
The interest rate options are particularly useful to a banking institution,
who generally have deposit and lending rates linked to a floating rate, say, 3M
LIBOR as benchmark rate. If the bank buys a cap at 4% and a floor of 1%
for say, 3 years, its deposit cost will not exceed 4% p.a. and its base income
(excluding credit premium) will not fall below 1% p.a., with full upside benefit
in both cases, avoiding impact of adverse movement of LIBOR for next 3 years.
A cross currency (P+I) swap (CCS) protects currency and interest rate
risks fully during the tenor of the loan. A CCS is a series of forward contracts
locking into fixed rate of exchange and fixed rate of interest (ref. Annexure
2). It is some-times preferable to hedge currency risk and interest rate risks
separately, as the borrower will have greater choice of using most appropriate
hedge instrument for each of the risks.
There are different types of interest rate swaps to suit requirements of
a business entity. Any swap must address an underlying business requirement.
A floating rate in itself may not present a risk for instance, an entity having
interest income and interest expenses linked to a common floating rate may
not need to hedge any risks. Similarly, a fixed rate in itself is not risk free, as it
is obvious from price fluctuations of any bond with fixed coupon.
An appreciation of underlying business risks is as important to a business
entity as the understanding of potential risks of a hedging instrument, before
choosing an appropriate hedging strategy.
mmm
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Annexure 1
Black & Scholes (GNK) Option Pricing
Black & Scholes option pricing model developed by economists Fischer
Black and Myron Scholes. The BSM (Black-Scholes-Merton) model is used to
value a European option on a underlying stock. The model assumes that stock
prices follow a log-normal distribution, which in other words can be put as
stock prices can go zero but never negative whereas there is no limit to the
upside to stock prices. The Garman Kolhagen (GNK) model is a slight variant of
the BSM model which is used to price European options on a foreign currency
underlying. The only difference is GNK is that an additional factor which is the
foreign currency interest rate is deducted from the domestic risk-free interest
rate since that is the income which is generated from an Fx asset just like
dividend is an income which is generated from a stock.
GARMAN KOLHAGEN FORMULA
c = S
o
exp(r
f
T)N(d
1
) K exp(r
d
T)N(d
2
)
p = K exp(r
d
T)N(d
2
) S
o
exp(r
f
T)N(d
1
)
u
1
=
T
d
2
= d
1
T
So Current Spot Rate
K Strike Rate
N Cumulative Normal Distribution Function
rd Domestic risk-free rate
rf Foreign currency risk-free rate
T Time to maturity
C European Call Option
P European Put Option
Annualized Volatility
74
EXPLANATION
The term N(d1) is also known as the delta or hedge ratio of a call
option. It is the sensitivity of the call option price (premium) to a small
change in the underlying asset. The term ln(So/K) measures the normalized
return by comparing underlying price with the option strike. The next term
(rd rf + ^2/2) measures the expected return which is the risk free rate
less the foreign currency interest rate plus half the variance of the fx asset.
These two terms together are divided by the x sqroot (time to maturity).
This term is the measure of the expected volatility movement till the option
expiry.
The term N(d2) is the probability of the underlying price ending above
the strike price at maturity. d2 is merely calculated by subtracting x sqroot
(time to maturity) from d1.
Finally the spot price is adjusted for the foreign currency interest rates
(income) whereas the strike rate is discounted by the domestic risk free rate.
The adjusted spot price is then multiplied with the call delta N(d1) and
the discounted strike is multiplied with the probability of exercise of call
option N(d2). The difference of these two gives the European call option
price.
The adjusted spot price is then multiplied with the put delta N(-d1) and
the discounted strike is multiplied with the probability of exercise of put
option N(-d2). The difference of these two gives the European put option
price.
CONCLUSION
To explain in layman language the BSM option pricing formula tries to
evaluate what are the chances of the option getting exercised on maturity and
also what would be the possible gain from the exercise of the option. Based on
these two criteria the BSM model tries to measure the probable cashflows or
the returns form the option on maturity. The present value of these probable
returns is the value of the option today.
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Annexure 2
Currency Swap (P+I) Calculation
Currency Swap (P+1) - ABC Ltd. with Bank XXX
USD Notional 10,000,000
INR equivalent at spot 469,000,000
Current Spot Rate 46.9000
Start Date 1-Sep-11
End Date 31-Aug-16
Pay Fixed Rate on INR 8.7034 %
Recv 6 LIBOR + 450 bps 4.5000 %
Valuation Date 12-Sep-11
Pay Side (INR)
Payment Dates Start Date End Date Principal Out Standing Interest Principal + Discount Discounted
Repayment (INR) Paid (INR) interest Factor (%) Cash Flows-
(Mifor) Int (INR)
1-Mar-12 1-Sep-11 1-Mar-12 46,900,000 469,000,000 20,353,462 67,253,462 4.3947 65,911,909
1-Sep-12 1-Mar-12 1-Sep-12 46,900,000 422,100,000 18,519,413 65,419,413 3.4178 63,315,675
1-Mar-13 1-Sep-12 1-Mar-13 46,900,000 375,200,000 16,193,304 63,093,304 3.1654 60,271,039
1-Sep-13 1-Mar-13 1-Sep-13 46,900,000 328,300,000 14,403,988 61,303,988 2.9632 57,872,498
1-Mar-14 1-Sep-13 1-Mar-14 46,900,000 281,400,000 12,144,978 59,044,978 3.0429 54,833,805
1-Sep-14 1-Mar-14 1-Sep-14 46,900,000 234,500,000 10,288,563 57,188,563 3.1440 52,161,029
1-Mar-15 1-Sep-14 1-Mar-15 46,900,000 187,600,000 8,096,652 54,996,652 3.5437 48,739,312
1-Sep-15 1-Mar-15 1-Sep-15 46,900,000 140,700,000 6,173,138 53,073,138 3.9699 45,468,186
1-Mar-16 1-Sep-15 1-Mar-15 46,900,000 93,800,000 4,070,692 50,970,692 4.4387 41,974,670
1-Sep-16 1-Mar-16 1-Sep-16 46,900,000 46,900,000 2,057,713 48,957,713 4.9163 38,558,587
529,106,711
Receive Side (USD)
Principal Out- FRA-USD Interest USDINR Principal+ INR Discounted
Repayment standing 6m Libor Recd Fwd Interest Equivalent Cash
(USD) (%) (USD) (P-I) Flows
1,000,000 10,000,000 0.48878 252,211 47.6432 1,252,211 59,659,350 58,469,283
1,000,000 9,000,000 1.15081 259,937 48.2127 1,259,937 60,745,022 58,791,601
1,000,000 8,000,000 0.61548 205,756 48.7068 1,205,756 58,728,542 56,101,521
1,000,000 7,000,000 0.22149 168,925 49.2091 1,168,925 57,521,724 54,301,946
1,000,000 6,000,000 0.82973 160,780 49.8583 1,160,780 57,874,520 53,746,826
1,000,000 5,000,000 0.99155 140,340 50.5483 1,140,340 57,642,253 52,574,835
1,000,000 4,000,000 1.44859 119,633 51.7358 1,119,633 57,925,059 51,334,534
1,000,000 3,000,000 1.67270 94,648 53.0416 1,094,648 58,061,841 49,742,049
1,000,000 2,000,000 2.12927 67,029 54.6823 1,067,029 58,347,631 48,049,622
1,000,000 1,000,000 2.40601 35,297 56.4080 1,035,297 58,399,060 45,994,495
529,106,711
PV of Pay Leg 529,106,711
PV of Rec Leg 529,106,711
NPV (INR)
76
Annexure 3
Commonly Used Greeks in Options
Option Pricing: Commonly used Greeks
Delta , measures the rate of change of option value with respect to
changes in the underlying assets price.
Theta , measures the sensitivity of the value of the derivative to the
passage of time: the time decay.
Rho , measures sensitivity to the interest rate: it is the derivative of
the option value with respect to the risk free interest rate (for the relevant
outstanding term).
Gamma , measures the rate of change in the delta with respect to
changes in the underlying price. Gamma is the second derivative of the value
function with respect to the underlying price.
Vega () is a measure of the amount an options price would be expected
to change in response to a unit change in the price volatility of the underlying
instrument
mmm
77
Developments in Indian Market
Regulatory Environment
Post-liberalisation in the mid-90s, significant changes that took place in
Indian economy included deregulation of interest rates and full convertibility of
rupee on current account. As a result, management of market risk volatility
of exchange rates and interest rates assumed importance with the market
players as well as with the regulators. Emergence of new private sector banks,
entry of foreign institutional investors, and successive liberalisation of external
commercial borrowings and overseas direct investment, added to the depth and
width of Indian financial markets.
Use of Derivatives
Use of derivatives in India is relatively a recent phenomenon. Forward
rate agreements and interest rate swaps were first introduced by RBI in July,
1999. Banks and primary dealers were allowed to offer forward rate agreement
and rupee interest rate swaps to corporates for hedging interest rate risk as
also to deal in them for their own balance sheet hedging and trading purposes.
Foreign currency swaps, though prevalent, were not directly regulated by RBI,
till the enactment of Foreign Exchange Management Act (FEMA) in 2000.
Regulations for use of foreign exchange derivative contracts were
formally issued only on 3rd May, 2000, vide FEMA Notification no. 25/RB-2000.
Operative instructions are being issued by RBI from time to time, now annually
codified under Master Circular on Risk Management and Inter-bank dealings.
Provisioning and accounting requirements for derivatives are also included in
RBI circulars on Prudential Norms for Off-balance sheet Exposures issued from
time to time.
The Reserve Bank of India (Amendment) Act of 2006 was a key
milestone in explicitly laying down the regulatory framework for OTC interest
rate, forex and credit derivatives. The Act defined derivative instruments and
conferred full powers on RBI for orderly development and maintenance of
forex markets.
6
CHAPTER
78
In view of growing popularity and complexity of OTC derivatives, RBI
issued Comprehensive Guidelines on Foreign Exchange Derivatives first in
April 2007, and updated and reissued the Guidelines in December 10 and May
11. Guidelines relating to Suitability and Appropriateness Policy for offering
Derivatives were further amended in August and November 2011.
The RBI guidelines on risk management are codified from time to time
in Master Circular on Interbank Risk Management last issued on July 2, 2011.
Similar Master Circulars are also issued in other areas of foreign exchange,
including exports and imports, ECB, ODI and FDI. RBI actions in the area of
foreign currency borrowings and foreign investment are directed by policy
decisions taken by Government of India from time to time.
Comprehensive Guidelines on Foreign Exchange Derivatives
The Guidelines define the derivative instruments that can be used
in Indian market by business entities, resident and non-resident individuals
and banks, the role of market makers and the conditions under which the
derivatives are to be issued and used. In view of the mis-selling of exotic
derivatives that caused extensive losses to corporates and banks during
2006-09, the guidelines relating to pricing of derivatives and suitability and
appropriateness policy are especially important. Some of the important rules
governing the issue of derivatives are reproduced below.
Market Makers
The guidelines are applicable only to OTC market, where only
Authorised Dealer 1 category of banks are eligible to be market makers. The
banks need to meet with minimum requirements in terms of net worth and
NPA, to be approved by RBI to be market makers. As market makers, the
designated banks can write options and have residual open positions in Rupee
derivatives, within limits approved by their boards. However, all cross-currency
options must be written only on back-to-back basis, the cover transaction
should be with an off-shore entity.
Type of Options
Only European type of options (options with fixed date of expiry) can
be offered in India. Forward contracts and options with current underlying
exposure (in the form of exports and imports) can be freely cancelled and
rebooked.
79
Underlying Exposure
All hedging contracts must have underlying contracted exposure with
the exception of hedging of probable exposure within approved limits. The AD
bank must verify documentary evidence of the contracted exposure. SMEs are
exempted from producing documentary evidence.
In one of its latest revisions to the derivative guidelines, RBI permitted
hedging of export/import transactions denominated in rupees, in order to
encourage rupee invoicing in external trade. The rupee exposure can be hedged
by the overseas trader through his local bank, or directly through the Indian
bank handling the documents, subject to compliance with kyc (know-your-
customer) norms.
Probable Exposure
Hedging of probable exposure (projected business) based on past
performance is permitted subject to a limit equal to previous years export /
import turnover, or average export/import turnover of previous three years,
whichever is higher. Only companies with minimum net worth of ` 200 cr and
export turnover of minimum ` 1,000 cr are permitted to use cost reduction
structures. 25% of such hedging must be delivery based and cannot be cancelled
before maturity. Balance 75% of hedges, once cancelled, cannot be rebooked.
FIIs
Foreign institutional investors are permitted to hedge their exposures in
India, using forward contracts and rupee options. Such hedges once cancelled,
cannot be rebooked rebooking is now allowed up to 2% of the original
notional amount.
FDI
Foreign direct investment can also be hedged for redemption of
investment or for payment of dividend. The hedge contracts once cancelled,
cannot be rebooked.
Cost Reduction Structures
Cost reduction structures are combination of buy/sell plain vanilla options,
used to reduce the cost of the buy option. Only listed companies and unlisted
companies with minimum net worth of ` 200 cr are permitted to use cost
80
reduction structures. The expiry date of options should not exceed the expiry
date of the underlying exposures.
Leveraged structures, digital options, barrier options, range accruals and
any other exotic products are not permitted.
Swaps
All currency and interest rate swap products are permitted instruments
to hedge currency and interest rate risks.
Foreign currencyINR swaps, hedging a loan exposure, once cancelled,
cannot be rebooked. Companies can also book FCINR swaps with a rupee
loan exposure as underlying, provided there is a natural hedge (FC income
to set off the liability) or an economic exposure companies without such
underlying exposure must have a minimum net worth of ` 200 cr.
Cross-currency swap, without involving rupee can be freely cancelled
and rebooked.
Interest rate option products such as caps and floors are permitted only
for cross-currency hedging. The products are not available in rupee market
Suitability & Appropriateness
RBI requires all AD banks to have a suitability and appropriateness
policy, so as to avoid mis-selling of derivative products. Banks are advised
to offer derivative products in general, and structured products in particular,
only to those users who understand the nature of the risks inherent in these
transactions and further that the products being offered are consistent with
users business, financial operations, skill and sophistication, internal policies as
well as risk appetite. Banks are required specifically to ensure that
The offered products are consistent with the Risk Management Policy
approved by the Board of the user company,
The derivative product is priced transparently, and
Potential risks are fully disclosed to the company, supported by a scenario
analysis.
Corporate Governance
The corporate clients intending to use derivatives must have a
documented policy approved by the Board and the Board Resolution should
81
specifically mention the permitted products, the approving authority, the
confirming authority who is authorised to sign confirmations / execute ISDA
Master Agreement and the authority to whom the derivative transactions need
to be reported. Thus the delegation of powers for derivative transactions would
be a part of the Policy.
The Policy should also include accounting and disclosure requirements
for derivatives used, including disclosure of MTM value of the outstanding
derivatives on reporting date.
Hedging Commodity Price Risk and Freight Risk
The comprehensive guidelines also set norms for hedging commodity
price risk and freight risks in international exchanges and where appropriate,
also in OTC market. Authorised Dealers who meet the minimum norms
prescribed by RBI are permitted to allow commodity hedging (for commodities
other than Platinum, gold and silver) including hedging of price risk of
petroleum and petroleum products, and hedging of freight risk by shipping and
oil companies. Hedging of commodity price risk and freight risk, outside the
norms set by RBI falls under approval route.
RBIs instructions in respect of suitability and appropriateness also applies
to commodity and freight hedging. Some of the operational differences as
compared to hedging of currency and interest rate hedging are:
In commodity price hedging, hedging of economic exposure is permitted.
For commodities, hedging of probable exposure is permitted up to 50%
of export import turnover of last years or 50% of average of last 3 years
whichever is higher (as against 100% in case of currency risk), and
Hedging of price risk of inventory is permitted in case of oil companies.
RBI master circulars and amendments to the circulars (prior to the issue
of next master circular which happens in July) should be referred for detailed
instructions.
External Commercial Borrowings
RBI instructions on external commercial borrowings (ECB) cover foreign
currency loans extended by offshore banks (including syndicated loans),
debt issues in global market, foreign currency convertible bonds (FCCB),
82
foreign currency exchangeable bonds (FCEB) and preference shares (whether
convertible or not) issued to foreign investors. FCCB and FCEB should also
comply with the notifications issued by Ministry of Finance, Govt. of India. Trade
credit for 3 years and above is also covered under ECB regulations.
RBI instructions on ECB are contained in the Master Circular on ECB,
issued on July 2, 2011 and circular on ECB Rationalisation and Liberalisation
issued on September 23, 2011. There are also other amendments issued in
September, 2011 relating to inter-group lending, credit enhancement and some
concessions to infrastructure sector, under approval route.
Broad features of ECB regulation are presented below.
Corporates and infrastructure finance companies, but excluding banks,
specialized financial institutions and other NBFCs, are permitted to raise ECB
under automatic route. Non-Government Organisations (NGO) engaged in
micro-financing activity can also raise ECB, but up to a lower limit of USD 5
mn with minimum repayment period of 3 years.
The ECB funds can be used only for the following purposes:
Investment in new projects, modernization/expansion schemes
Import of capital goods
Infrastructure projects
Overseas direct investment
Acquisition of shares in disinvestment process
Purchase of spectrum allocation, and
On-lending to self-help groups or for micro-finance activity by NGOs
Infrastructure finance companies can also use 50% of ECB availed
by them for on-lending to the infrastructure sector, subject to the norms
prescribed by RBI.
Maximum borrowing under ECB in a financial year is $ 20 mn for
average repayment period of 3 years, and $ 750 mn for average period of 5
years and above. Minimum period of borrowing is average 3 years.
Corporates in specified service sectors viz. hotel, hospital and software,
can avail of ECB up to USD 200 million or equivalent during a financial year.
The ECB funds however, cannot be used for land acquisition.
83
For NGOs the cap on ECB is set at USD 5 mn. in a financial year.
RBI has imposed all-in cost ceiling of 6M LIBOR +300 bp up to 5 years
and 6M L+500 bp for more than 5 years. The all in cost includes interest and
other fees and expenses payable in foreign currency.
Under automatic route, as soon as the ECB is sanctioned, the borrower
company needs to register the loan with RBI and obtain a Loan Registration
No. through the AD bank. The LRN is to be used for all future transactions
under the loan facility. (Similar rules apply to debt issues in global market
LRN is to be obtained as soon as the terms of issue are finalized.)
As a measure to control the capital flows, RBI has put a cap of USD 30
bn for all the ECB to be raised during the f y 2011-12.
RBI has advised the banks to ensure that the currency and interest rate
risks of the ECB are hedged appropriately, unless the borrower company has
a natural hedge.
Recent measures relaxing ECB regulations (Sept 11) include:
Under automatic route, foreign equity holders are eligible lenders provided
they hold minimum 25% equity (which now includes free reserves) and
the ECB liability to debt ratio does not exceed 4.
Associate companies within a group are also eligible lenders, provided
the group companies are held by the same parent holding minimum 51%
equity in the Indian company raising the ECB.
Infrastructure companies are permitted to raise ECB in Chinese currency,
renminbi under the approval route, subject to an annual cap of USD 1 bn.
ECB, apart from being a preferred source of funds for corporate
entities, is also a means of attracting foreign investment to India, and further
liberalization of ECB regulations should result in an increase in capital inflows.
Foreign Direct Investment (FDI)
RBI instructions for FDI are contained in their latest Master Circular
on Foreign Investment in India issued on 1 July, 2011. The foreign investment
includes
Foreign Direct Investments by persons resident outside India, under
Automatic Route or Govt. Route
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Foreign Portfolio by FIIS, and non-resident Indians/persons
Investments of Indian origin
Foreign Venture Capital by foreign venture capital investors /funds
Investments registered with SEBI
Investment in Debt Market FIIs and NRI/PIO investors
Investments on non- NRI/PIO
repatriable basis
Broadly foreign investors can enter into Indian markets, either by
subscribing to equity and debt issues in primary market (FDI and ECB) or
by purchasing equity and tradable paper in secondary market (portfolio
investment).
RBI elaborates procedural part of the FDI, under provisions of FEMA
(Notification No. FEMA 20 /2000-RB dated May 3, 2000) based on the FDI
Policy of Govt. of India. The Government issues a Consolidated FDI Policy
Circular every half-year, last such circular being of 30 September 2011, effective
for the half-year commencing from October 1, 2011. (Master Circular of RBI is
based on earlier FDI Policy Circular of 31 March, 2011 hence latest circular
may be referred to for sectoral caps etc.)
The FDI Policy permits investment by automatic route or by prior
approval by Foreign Investment Promotion Board (FIPB). The policy also fixes
sectoral caps, industry-wise, for manufacturing, services and financial sectors of
the economy. There is also a negative list of activities where FDI is prohibited.
With progressive liberalization of the FDI Policy, in most sectors 100%
foreign investment is allowed, subject to some minimum norms. 100%
FDI is allowed in manufacturing and services sector under automatic route,
in industries like mining, drugs and pharmaceuticals, power generation,
transmission & distribution (excluding atomic energy), Greenfield projects,
wholesale and export trading, and financial services (NBFCs). 100% FDI is also
allowed in select agricultural projects like horticulture and animal husbandry.
49% to 74% investment is allowed in sectors including passenger-air services,
telecommunications, private sector banking (FII+FDI max 74%), asset
reconstruction companies, commodity exchanges, housing infrastructure and
development projects. FDI is restricted only in a few sectors like PSU banking
(max. 20%), insurance (max. 26%), and print media (max. 26%). Defence
production has been recently opened to foreign investment, with a cap of 26%.
Most case with FDI cap at 49% or lower require prior approval of FIPB.
85
FDI is not permitted in the following activities:
Retail Trading (except single brand product retailing)
Atomic Energy
Lottery Business including Government/private lottery, online lotteries,
etc.
Gambling and Betting including casinos, etc.
Business of chit fund
Nidhi company
Trading in Transferable Development Rights (TDRs)
Activities/sectors not opened to private sector investment
Agriculture (excluding Floriculture, Horticulture, Development of seeds,
etc. and services related to agro and allied sectors) and Plantations (other
than Tea Plantations)
Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or
of tobacco substitutes
Indian companies can issue equity, compulsorily convertible debentures
and preference shares to foreign investors. Pricing and valuation guidelines
are issued by SEBI (for listed companies) and RBI (for unlisted companies).
Indian companies also have general permission to convert ECB, convertible
debentures, royalty payments and technical know-how fees under automatic
route. Issue of shares against import of capital goods is permitted with prior
approval of FIPB. In all cases pricing and valuation norms of RBI/SEBI need to
be followed.
Indian companies who are eligible for FDI and who are also eligible to
raise funds in domestic market, are allowed to issue American Depository
Receipts and Global Depository Receipts in accordance with the Scheme for issue
of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository
Receipt Mechanism) Scheme, 1993, and guidelines issued by RBI from time to
time. The funds so raised cannot be invested in real estate or stock market.
Foreign companies are permitted to issue Indian Depository Receipts
(IDR) subject to and under the terms and conditions of Companies (Issue of
Depository Receipts) Rules, 2004 and subsequent amendment made thereto and
the SEBI (DIP) Guidelines, 2000, as amended from time to time. FIIs and NRIs
may invest and trade in the IDRS subject to the Foreign Exchange Management
86
(Transfer or Issue of Security by a Person Resident Outside India) Regulations,
2000 notified vide Notification No. FEMA 20/2000-RB dated May 3, 2000,
as amended from time to time. IDRs are denominated in rupees, and issue
proceeds of IDRs should be repatriated immediately outside India.
Portfolio Investment Scheme
FIIs registered with SEBI are permitted to invest up to 10% of equity
capital or 10% of the paid-up value of the specific series of convertible
debenture, subject to a cap of 24% of equity and 24% of value of convertible
debentures, respectively. The Indian company can increase the cap, subject
to sectoral limits imposed by Government, by passing a board resolution.
Prohibition on investment in specific sectors is similar to that of FDI.
Investment in Debt Market
FIIs are allowed to invest in Government securities, non-convertible
private corporate bonds, and commercial paper subject to a ceiling. Currently
the ceiling on FII investment in debt market is USD 40 bn, composing of USD
25 bn for infrastructure sector (with residual period minimum 5 years and
minimum lock-in period of 3 years), USD 15 bn for permitted corporate debt
paper and USD 10 bn for G-sec (out of which USD 5 bn is for securities with
minimum residual period of 5 years).
FIIs can invest in tier-2 bond issues of banks, subject to a cap of 10% of
the issue for each investor, and overall ceiling of 49% of the issue for foreign
investment. FIIs can also invest in perpetual bond issues (tier-1 capital) with
similar restrictions of 5% of the issue per investor, and overall ceiling of 24%
of the issue for foreign investment.
Overseas Direct Investment (ODI)
ODI is capital outflow where Indian companies invest in overseas
ventures. RBIs latest regulations on ODI are contained in the Master Circular
on Direct Investment by Residents in Joint Venture (JV) / Wholly Owned
Subsidiary (WOS) Abroad, issued on 1 July, 2011, and are covered under
Foreign Exchange Management (Transfer or Issue of any Foreign Security)
Regulations, 2004 dated July 7, 2004.
Indian companies are prohibited from investing in foreign companies
engaged in real estate or in trading transferable development rights, or banking
business, without prior permission from RBI.
87
Indian companies can invest in overseas joint ventures/wholly owned
subsidiaries up to 4 times of their net worth, without prior approval of RBI,
subject to the prohibition imposed above. The ceiling does not apply in case
the funds are sourced from the foreign currency accounts of the company, or
from proceeds of ADR/GDR issue, or from foreign currency resources held
outside India.
The investment overseas includes investment in equity, loans and
guarantees extended to or on behalf of the overseas company. The guarantees
so extended, if any, should be for fixed amount and fixed terms, and should
not be open-ended. However any charge on immovable property or pledge
of shares as security by the Indian company/group in favour of the overseas
entity would require prior approval of RBI. Guarantees issued to step-down
subsidiaries (after first generation) also needs prior approval of RBI.
In case of partial or full acquisition of a foreign company where the
investment is more than USD 5 mn, or where the acquisition is by way of
swap of shares or by issue of ADR/GDR, the valuation norms prescribed by
RBI need to be followed.
Investment in the overseas venture can be funded from Rupee resources,
issue/swap of shares (including ADR / GDR), FC resources mobilized by the
company by ECB / FCCB, or from EEFC funds in the last two cases the
ceiling of 400% over net worth does not apply.
The FDI regulation of RBI are fairly liberal and have led to many Indian
companies making large acquisitions overseas.
Liberalised Remittances Scheme (LRS)
While the liberalization largely pertained to corporate financing, RBI has
introduced liberalized Remittances Scheme to allow individuals to access FX
resources with minimum restrictions. Under this scheme, resident individuals,
including minors, are allowed to remit freely USD 20,000 per financial year,
for any permissible capital or current account transactions. The funds can be
used for investment in equity/debt instruments, acquisition of property or any
other assets overseas. The residents can also remit the funds towards gifts and
donations also.
The funds under this scheme cannot be used for any purpose specifically
prohibited or restricted under FEMA (such as purchase of lotteries, etc.), for
margin trading, or for setting up a company. The funds cannot also be remitted
88
directly or indirectly to Bhutan, Nepal, Pakistan and Mauritius, or to any
country which is subjected to international sanctions.
The LRS is in addition to facilities already made available to individuals
under current account (ref RBI Master Circular on Miscellaneous Remittances).
The LRS can also be used to subscribe to mutual funds overseas. The funds
remitted as well as any earnings on investment of funds can be retained
overseas.
Other RBI Regulations
Other RBI regulations pertaining to exports, imports, miscellaneous
remittances, foreign guarantees, etc. deal mostly with operational issues and
issues relating to payment and settlements. As current account operations are
already fully liberalized, they are not being dealt with here.
Developments in Indian Markets
Over the last decade, Indian economy has witnessed an average annual
growth rate of 8%. Increase in economic activity, coupled with a liberal
currency exchange regime, resulted in a dynamic foreign exchange market,
which is also the most globalised sector of the economy. The forex market,
apart from reflecting expanding exim trade, is closely linked to debt and equity
markets, absorbing huge capital flows.
Daily turnover in the forex market is estimated at around USD 38 bn,
an increase of 75% over the level of 21 bn in April 2007, as reported in
the BIS survey. The share of rupee in global fx turnover has also increased
correspondingly from 0.7% to 0.9% (as at April 2010) higher than Chinese
renminbi and on par with the highest turnover amongst emerging market
countries (BRICS), but still not very significant as compared to major currencies
which are freely convertible.
Currency and interest rate options are widely used in the inter-bank
market as well as end-user market. While no precise statistics are available for
latest periods, aggregate outstanding notional of derivative contracts is believed
to be near about USD 2 trillion. (last available : FC forwards USD 668 bn,
FC options USD 106 bn and interest rate swaps USD 995 bn as at end Dec.,
2009 source: RBI).
An important segment of derivative market in India is currency futures
which are being traded actively in two of the exchanges. The currency futures
89
are settled in rupee terms, hence do not have a direct impact on rupee
exchange rates. However, the futures market can also be used for hedging
currency risks, and is more importantly used for a) arbitraging with forward
market, and c) trading in currencies, which is not otherwise permitted in
foreign exchange market. The annexure to this section gives brief features of
the exchange traded products.
Foreign direct investment into Indian capital market during the year
2010-11 amounted to USD 30.383 bn, about 25% less than previous years
flow of USD 37.763 bn. India has a surplus on capital account, which is funding
the deficit on trade account, making the overall balance of payments positive.
The BOP statistics for first quarter of the current year reveal that the current
account deficit of USD 14.205 bn was set off by net capital inflows of USD
16.115 bn. (consisting of FDI 7.188 bn, Portfolio investments of USD 2.541 bn
and ECB flows of USD 6.386 bn).
While there is a slow down in FDI flows on account of global liquidity
issues and sovereign debt crisis in European Union, Indian corporates have been
raising ECB aggressively, to benefit from interest arbitrage. Indian companies
raised a total ECB of USD 16 bn in the first five months of current f.y, as
against total ECB of USD 26 bn in the previous f.y. Most of the ECB was for
funding new infrastructure projects and power plants.
Despite the turbulence in global markets, the trade deficit of India has
narrowed down by 10% as at end of FY 2010-11, as shown below:
(USD bn) 2009-10 2010-11 increase
exports 178,751 254,402 42%
imports 288,373 352,575 22%
trade balance -109,622 -98,173 -10%
Fluctuations in the price of oil (which constitutes about 1/3rd of total
imports) and fluctuations in rupee exchange rates are two important factors
that affect our trade performance.
Capital flows not related to business sector include mainly NRI deposits
and remittances under Liberalised Remittances Scheme.
NRI deposits are being maintained steadily, on account of higher interest
rates in India, as also several facilities being extended by RBI to NRIs. NRI
90
deposits as at end of f.y. 2010-11 amounted to USD 51.682 bn as compared
to USD 47.890 bn at the previous year-end.
Personal remittances under liberalized scheme crossed USD 1 bn,
amounting to USD 1163 mn for the year 2010-11. For the first four months
of current f.y., the remittances amounted to USD 340 mn. About 50% of the
remittances were for the purpose of gifts and investment in equity overseas.
Reserve Banks foreign exchange reserves as at end September 2011
amounted to USD 280 bn one of the highest amongst Asian countries.
Gradual liberalization of various exchange control regulations suggest that RBI
is firmly on the way to full convertibility on capital account.
mmm
91
Supplement: Exchange Traded Products Currency Futures,
Options and Interest Rate Futures
Futures are forward contracts traded in a futures exchange. Under a
futures contract the seller agrees to deliver to the buyer a specified security/
currency or commodity on a specified date, at a fixed price. Futures relating
to exchange rates (currency futures), Interest rates (bond futures) and equity
prices (stock/index futures) are known as financial futures, as distinct from
commodity futures (oil/metal/agro-products, etc.). Futures contracts are of
standard sizes with prefixed settlement dates, with the exchange as counter-
party.
Currency futures are traded globally for major currencies (EURO, GBP,
JPY, CHF, AUD and CAD) in terms of USD. A contract of GBP 25,000 is
traded at LIFFE for delivery on 28th March, say at 1.6650, as against spot
exchange rate of 1.60. The contract implies that on 28th March the seller
would deliver to the holder of the contract, GBP 25000 against payment
of equivalent USD at the rate of 1.6650. On the settlement date, if the
market rate of GBP is 1.70, the seller will pay to the holder the difference in
contracted price and spot price on that date (1.70-1.6650 = USD .035 per
Pound). If the market price is less than the contracted price, the buyer of the
contract will bear the loss. Unlike in options, the contract must be executed
by both the parties.
While the futures contract works like a forward contract, there are three
important differences: i) The buyer and seller of the contact do not deal with
each other but they deal with the Futures Exchange as counter party the
Exchange guarantees performance of the contract. ii) Technically, the contract
is settled each day, in the sense the contract is marked-to-market daily, and
losses if any are recovered from the holder by way of margin. Gains if any
are also credited to the margin account. iii) Unlike forwards, futures contracts
are actively traded on the exchange, the contracts are bought and sold several
times during the day.
In India, futures market for USD/INR commenced in August 2008. The
contract size is USD 1,000 and all settlements take place in Rupees. Trading in
cross-currency Rupee contracts (Euro/INR, GBP/INR and JPY/INR) has also
commenced from last quarter of 2009. Currency futures are traded actively in
the futures segment of NSE, and in the MCX-SX (promoted by the commodity
exchange, MCX), with aggregate daily turnover exceeding USD 8 bn. (October
2011). United Stock Exchange, promoted by leading banks, is a recent entrant
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in the futures market, commanding about 10% of the market. However, there
is little liquidity in contracts maturing beyond 3 months.
RBI permitted currency options as an exchange traded product, trading
in which commenced from October 2011. The products traded are monthly
and quarterly USD/INR option contracts. Currently the options are traded in
NSE with daily average turnover at around USD 300 mn, roughly about 10%
of the futures volume.
Interest rate futures are contracts written on fixed income securities
(Treasury bills, bonds, etc.) of specified size. Contracts written on treasury
bills and euro-dollars (with LIBOR/Euribor as benchmark) trade in short-term
interest rates, while contracts on treasury bonds or corporate bonds deal in
medium- and long-term interest rates. Treasuries, being risk free instruments,
indicate movement in market rate of interest. The Treasuries are traded at a
discount, the discount being equal to interest rate for the period. A futures
contract of USD 1 million, for 1 year on a Treasury bill trades at 96 if the
expected interest rate at the end of the period is 4% (i.e., 100-4 = 96, futures
price). The price of the contract fluctuates daily according to the perception
of interest rates for the residual maturity. T-bill futures are traded with US
treasury bills and notes as underlying instruments, while Euro Dollar bonds are
traded on the basis of LIBOR, or inter-bank deposit rates outside USA. Bond
futures on the other hand are traded at specified yield levels, reflecting changes
in long-term interest rates. The contract size, delivery terms and trading
practices differ from exchange to exchange.
Interest rate futures help hedge interest rate risk. The hedge is based
on the inverse relationship between the interest rates and bond prices, i.e.,
if the interest rate goes up, bond prices come down, and bond prices would
move up if interest rates decline. If a corporate expects to borrow USD after
3 months, but would like to lock into the current interest rate, the corporate
will short sell the 90-day treasury futures contract of comparable size. If the
interest rates rise on the date of availing the loan, the bond price would
have correspondingly fallen, and the profit earned on the T-bill futures would
compensate for the higher interest on loan amount.
In India, interest rate futures were re-launched in August 2009 after
the earlier version failed to take off in 2003. The re-launch was expected to
take care of the earlier flaws in the IRF product design which resulted in the
product becoming defunct within a few days of its launch. Currently NSE is the
only exchange offering the IRF products.
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The contract size is ` 2 lakhs and is based on a 7% synthetic 10-year
Government security. The contracts are to be settled physically on CTD
(cheapest to deliver) basis. However, liquidity continues to be low and the
market is yet to take off, mainly on account of delivery related problems.
The RBI came out with a circular allowing 91-day T-bill future which
commenced trading on the NSE from 4th July, 2011. The t-bill futures unlike
the g-sec futures are cash settled, thus retail participation in the t-bill futures
is possible.
The t-bill future being cash settled product was expected to survive,
unlike the g-sec futures. However, after a promising debut with turnover
around ` 700 cr on the first day, the interest in the t-bill futures appear to
have totally disappeared, with current turnover in the market being almost
nil. The reason appears to be lack of depth in the T-bill market, as T-bills
are not actively traded in secondary market. Price discovery of the T-bills is
also considered to be weak, as they are issued by RBI regularly in specified
amounts, with a captive consumption by banking sector.
Thus currency futures and currency options are the only active segments
of the futures market. The contract terms of currency futures and options in
permitted currencies is attached for reference.
mmm
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Contract Terms: Currency Futures
Symbol USDINR EURINR GBPINR JPYINR
Market Type N N N N
Instrument Type FUTCUR FUTCUR FUTCUR FUTCUR
Unit of trading 1 - 1 unit 1 - 1 unit 1 - 1 unit 1 - 1 unit
denotes denotes denotes 1000 denotes
1000 USD. 1000 EURO. POUND 100000
STERLING. JAPANESE YEN.
Underlying / Order The exchange The exchange The exchange The exchange
Quotation rate in Indian rate in Indian rate in Indian rate in Indian
Rupees for Rupees for Rupees for Rupees for 100
US Dollars Euro. Pound Sterling. Japanese Yen.
Tick size 0.25 paise or INR 0.0025
Trading hours Monday to Friday 9:00 a.m. to 5:00 p.m.
Contract trading cycle 12 month trading cycle.
Last trading day Two working days prior to the last business day of the expiry
month at 12 noon
Final settlement day Last working day (excluding Saturdays) of the expiry month.
The last working day will be the same as that for Interbank
Settlements in Mumbai
Quantity Freeze 10,001 or greater
Base price Theoretical Theoretical Theoretical Theoretical price
price on the price on the price on the on the 1st day
1st day of 1st day of the 1st day of the of the contract.
the contract. contract. contract. On all other
On all other On all other On all other days, DSP of the
days, DSP of days, DSP of days, DSP of contract
the contract the contract the contract
Price operating Tenure +/-3 % of
range up to 6 base price.
months
Tenure +/- 5% of
greater base price.
than 6
months
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Position limits Clients higher of 6% higher of 6% higher of 6% of higher of 6% of
of total open of total open total open total open
interest or interest or interest or GBP interest or JPY
USD 10 EURO 5 5 million 200 million
million million
Trading higher of 15 higher of 15% higher of 15% higher of 15%
Members % of the total of the total of the total of the total open
open interest open interest open interest or interest or JPY
or USD 50 or EURO 25 GBP 25 million 1000 million
million million
Banks higher of 15% higher of 15% higher of 15% higher of 15%
of the total of the total of the total of the total open
open interest open interest open interest interest or JPY
or USD 100 or EURO 50 or GBP 50 2000 million
million million million
Initial margin SPAN Based Margin
Extreme loss margin 1% of MTM 0.3% of MTM 0.5% of MTM 0.7% of MTM
value of gross value of gross value of gross value of gross
open position open position open position open position
Calendar spreads ` 400 for ` 700 for ` 1500 for ` 600 for
spread of spread of spread of spread of 1
1 month 1 month 1 month month
` 500 for ` 1000 for ` 1800 for ` 1000 for
spread of 2 spread of 2 spread of 2 spread of 2
months months months months
` 800 for ` 1500 for ` 2000 for ` 1500 for
spread of 3 spread of 3 spread of 3 spread of 3
months months and months and months and
` 1000 for more more more
spread of 4
months and
more
Settlement Daily settlement : T + 1
Final settlement : T + 2
Mode of settlement Cash settled in Indian Rupees
Daily settlement price Calculated on the basis of the last half an hour weighted average
(DSP) price.
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Final settlement price RBI reference RBI reference Exchange rate Exchange rate
(FSP) rate rate published by published by RBI
RBI in its Press in its Press
Release Release
captioned RBI captioned RBI
reference Rate reference Rate
for US$ and for US$ and
Euro Euro
Contract Terms: USD/INR Options
Symbol USDINR
Market type N
Instrument type OPTCUR
Option type Premium style European Call & Put Options
Premium Premium quoted in INR
Unit of trading 1 contract unit denotes USD 1000
Underlying / Order The exchange rate in Indian Rupees for US Dollars
Quotation
Tick size 0.25 paise i.e. INR 0.0025
Trading hours Monday to Friday 9:00 a.m. to 5:00 p.m.
Contract trading 3 serial monthly contracts followed by 1 quarterly contracts of the
cycle cycle March/June/September/December
Strike price 12 In-the-money, 12 Out-of-the-money and 1 Near-the-money.
(25 CE and 25 PE)
Strike price intervals INR 0.25
Price operating range +/- 99% of base price
Quantity freeze 10,001 or greater
Base price Theoretical price on the 1st day of the contract.
On all other days, DSP of the contract.
Expiry/Last trading day Two working days prior to the last business day of the expiry
month at 12 noon.
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Exercise at expiry All in-the-money open long contracts shall be automatically exercised
at the final settlement price and assigned on a random basis to the
open short positions of the same strike and series.
Final settlement day Last working day (excluding Saturdays) of the expiry month.
The last working day will be the same as that for Interbank
Settlements in Mumbai.
Position limits The gross open positions across all contracts (both futures and
options) shall not exceed the following.
Clients Higher of 6% of total open interest or USD 10
million
Trading Higher of 15% of the total open interest or USD
Members 50 million
Banks Higher of 15% of the total open interest or USD
100 million
Initial margin SPAN Based Margin
Extreme loss margin 1.5% of Notional Value of open short position
Settlement of premium Premium to be paid by the buyer in cash on T+1 day
Settlement Daily settlement : T + 1
Final settlement : T + 2
Mode of settlement Cash settled in Indian Rupees
Final settlement price RBI reference rate on the date of the expiry of the contact
(FSP)
mmm
Symbol USDINR
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Managing Bank Treasury
Bank treasury differs from corporate treasury in that the bank is a
market maker and is permitted to trade in currencies, apart from meeting the
requirements of its merchant customers. While market risk is essentially the
same for banks and corporates, the way banks manage their treasury risk is
slightly different on account of involvement of public funds. Most banks have
integrated treasury, where foreign exchange, securities trading and money
market transactions are intertwined, leading to concentration of market risk.
Bank management is highly sensitive to treasury risk, as the risk arises
out of high leverage the treasury business enjoys. The risk of losing capital
is much higher than, say, in the credit business. Banks capacity to extend
loans is limited by the resources at its command, that is, deposits and other
borrowings. In case of a loan, the risk is limited to the principal and interest,
which may be lost, fully or partly, over a period of time. Most of the loans are
also secured by tangible assets. The risk is capped by the amount invested in
the loan asset. Potential loss in loan assets is known as credit risk.
Treasury on the other hand, has a very low funding requirement,
which we call as high leverage. For instance, treasury can buy and sell foreign
exchange of say, USD 10 mn without any direct investment of funds, except
for allocation of risk capital as per capital adequacy requirement of RBI. At the
same time, an adverse movement of the exchange rate by ` 1 may result in a
loss of over ` 1 crore to the bank which is a straight loss of capital. Similarly,
a rise in yield levels may erode the value of marketable securities held by the
treasury. Thus the market risk, comprising of exchange rate and interest rate
fluctuations has a direct impact on the banks operational profits.
A second reason for management concern is large size of transactions
done at the sole discretion of the Treasurer. In foreign exchange markets,
minimum deal size is generally USD 5 mn, and in securities market it is ` 5
cr. In derivatives, minimum notional amount for an interest rate swap is ` 25
cr. The limits are accordingly delegated to the Treasurer or the Chief Dealer
in advance, and individual market deals rarely need specific approval from the
management. If the Treasurer commits an error of judgment, consequent losses
to the bank would be enormous.
7
CHAPTER
99
A third factor closely connected to the above is that the losses in
treasury business materialize in very short-term, and the transactions, once
confirmed, are irrevocable hence no corrective action is possible. Particularly
in foreign exchange, markets react so fast that profits or losses on trade deals
are almost instantaneous. Traders are generally not allowed to hold open
positions for long, as the risk of loss increases with time.
The source of risk in treasury activity is variation in the market price
of currency or security, when there is a gap between the buy leg and sell leg
of the transaction. The risk is hence termed as market risk, as opposed to
credit risk of loan assets of the bank. The variability of the price, upward or
downward, is known as volatility. In case of currency, it is known as volatility of
exchange rate and in case of securities, it is volatility of interest rates (security
prices have inverse relationship with interest rate movement).
Treasury also faces funding risk, or liquidity risk, as all settlements need
to be funded. Treasury is also required to bridge the funding gaps of the bank
by borrowing funds in the market at short notice. Treasury is responsible to
meet with reserve requirements, i.e. CLR and SLR, which effectively block cash
available to the bank. Liquidity involves managing cashflow mismatches, and
if the liquidity is not readily maintained, interest costs will go up, sometimes
threatening the viability of banking operations. Liquidity and interest rate risk
are two sides of the same coin, but the risks are dealt separately, as banks are
highly sensitive to liquidity risk.
Treasury risks are primarily managed by conventional control and
supervisory measures, mostly in the nature of preventive steps, which may be
divided into three parts:
Organisational Controls
Exposure Ceiling
Limits on trading positions and stop-loss limits
Organisational controls
The organisational controls refer to the checks and balances within the
system. Treasury is basically divided into three parts: the front office, back office.
The front office generates deals with counter-party banks (purchase and
sale of foreign exchange, securities, etc. and lending and borrowing operations).
Treasury may enter into currency dealings either on its own (Trading Book),
or on behalf of clients (Merchant Book) or for banks internal requirement.
100
Security deals are either for Banks SLR requirement, or for Treasurys own
trading book. Though Treasury may also buy and sell securities on behalf of its
retail clients, the activity as on date is not very significant many banks have
associate companies specializing in fund management. Treasurys money market
activity is exclusively to meet banks own requirements.
Front office is headed by Chief Dealer, assisted by other dealers in
foreign exchange, securities market and money market. Larger banks may
have dealers specializing in specific activities, such as corporate dealers, cross-
currency dealers, equity traders, etc.
The back office is responsible for confirmation, accounting and settlement
of the deals. The back office obtains independent confirmation of each and
every deal from the counterparty and settles the deal only if it is within the
exposure limits allowed for the counterparty. Back office also verifies that the
rates/prices mentioned in the deal slips are conforming to the market at the
time the deal is entered into. The back office has the overall responsibility for
compliance with exposure limits and position limits imposed by the Management
and RBI, as well as for accuracy and objectivity of the transaction detail.
Banks also have a Middle Office (mid-office), which is responsible for
risk management and management information system (MIS). Mid-office would
ensure treasurys compliance with Board approved policies bearing upon FX
risk management, investment management and liquidity management. Key
responsibilities of Mid-office include monitoring compliance with risk limits set
in the respective policies, ensuring compliance with regulatory requirement,
daily mark-to-market (MTM) valuation of Treasury positions, verification of
pricing of treasury products, including derivatives, and periodic reports to
top management. Mid-office maintains the overall risk profile of Treasury and
monitors the liquidity and interest rate risks closely, in line with Asset Liability
Management (ALM) guidelines. In quite a few banks, the ALM support group is
a part of Mid-office, or works closely with the Mid-office.
Front Office and Back Office functions need to be segregated totally,
with both offices reporting independently to the Treasury Head. Mid-office may
report directly to the Treasury Head or to a senior executive, outside Treasury,
such as Chief Risk Officer, to ensure better risk control.
Internal Controls
The most important of the internal controls are position limits and
stop loss limits. The limits are imposed on the dealers who trade in foreign
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exchange and securities. Trading is a high-risk area, vulnerable to sudden market
fluctuations and the limits imposed by management are preventive measures to
avoid or contain losses in adverse market conditions.
The trading limits in the context of foreign exchange are of three kinds:
(i) limits on deal size (ii) limits on open positions and (iii) stop-loss limits. All
limit are expressed in absolute amounts.
Limits on deal size prescribe the maximum value for a buy/sell
transaction. The limit is a protection against potential losses on the deal. The
limit generally corresponds to the marketable size of the transaction, and
applies only to trade deals (and not to merchant deals).
Treasury is expected to square-off their positions at the end of the day
(i.e. sell currencies bought, and buy currencies sold) so as to make the balance
FC position nil, except for trading positions which are specifically allowed by
the Management.
Open positions refer to a) end-of-the day residual positions in foreign
currencies, after squaring off and b) trading positions, where the buy/sell
positions are not matched. The Treasury may buy USD 1 million, and hold
on to the position with an intention to sell when the USD appreciates against
the Rupee. Not only there is a potential loss if Rupee does not appreciate,
but there is also a carry cost, as the Treasury loses interest on the USD
funds during the holding period. The management therefore limits the size
of open or unmatched positions. The limits in foreign exchange trade are
defined as daylight and over night the day light limits pertain to the intra day
positions, say if the dealer purchases currency in the morning and sells it in the
afternoon. As the forex market is very active, the currency prices may move
from moment to moment, the currency may lose value in the mean time. The
overnight limits are smaller as the dealers may continue to hold the position
for next day.
Position limits are prescribed currency-wise as also for aggregate
position expressed in Rupees. The overnight limits are to be pre-approved by
RBI, who also prescribe the method of arriving at the aggregate position.
Net open position in a single currency is rupee value of net spot
position, net forward position and net options position. Net spot position is
difference between foreign currency purchases less foreign currency sales,
at the end of day. Net forward position is forward receivables less forward
payables. Net option position is delta equivalent spot currency position for
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outstanding options. Currency-wise net short and net long positions are to
be added up separately, and the higher of short or long positions constitutes
overall net open position.
Even when there are matching positions, there is scope for loss if the
delivery is at different points of time. In a swap deal, the dealer may purchase
USD at spot and sell it forward, say, after three months. It is a matched deal
as the purchase and sale prices are prefixed and hence there is no exchange
risk. However, the forward prices are derived out of interest rate differentials
and there is an opportunity cost if interest rates move adversely during the
transaction period. The risk in forward positions is measured by gaps (residual
time for completion of the transaction) which are then capped with a gap
limit akin to position limits on spot trading positions. All the forwards are
revalued periodically (generally monthly, but in most computer systems, daily
valuations will be available) and the outstanding positions in each time bucket
are subjected to gap limits. The gap limits are internally approved by the
management.
Position limits and gap limits attract capital requirement, as prescribed
by RBI.
Similar controls exist for securities trading, where the size of the deal,
maximum value of securities held for trading and holding period are defined by
the Management. For non-SLR securities, minimum credit rating requirement is
also prescribed by the Management.
Stop-loss limits represent the final stage of controlling trading operations.
When the market moves adversely, the open positions will result in loss. A
dealer typically would like to wait till the market turns around, so that he
can close the position with a profit. There is an added risk in that the market
correction may not take place as anticipated, and the losses may continue to
accumulate in the mean time. The stop-loss limits prevent the dealer from
waiting indefinitely and limit the losses to a level which is acceptable to the
management (which the bank is in a position to absorb). Any violation of stop-
loss limit is viewed seriously by the management.
The stop-loss limits are prescribed per deal, per day, per month as also
an aggregate loss limit per year. Back office need to monitor all the limits
meticulously. Back office is also responsible for valuation of deals, and if it is
found out that the open positions upon valuation are found to be resulting in
loss, the front office should be immediately informed for applying the stop-loss
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limits. (normally, it is front office who monitor the positions, and back office
only keeps a second check). The forex trading positions need to be valued
(marked to market) daily for this purpose.
Stop-loss limits are applied on securities trading in a different manner,
as price movements in securities market are larger and more irregular, as
the market is less liquid as compared to forex market. The market risk is
controlled in terms of mark-to-market value of the trading portfolio, applying
risk measures such as VaR and duration,
Exposure Ceiling Limits
Exposure limits are kept in place to protect the bank from credit risk.
Credit risk in Treasury may be split into default risk and settlement risk.
Default risk is typically when the bank lends in the money market (mainly to
other banks), the borrowing bank may fail to repay the amount on due date.
Similar risk is there in repo transactions also. Even though inter-bank market
is considered to be relatively risk free, it is not uncommon that a weak bank
may suddenly become bankrupt, or, there is a run on the bank squeezing its
liquidity. Even assuming that there is no credit risk in short-term lending, it is
not prudent that Treasury lends its entire surpluses to a single bank or to a
handful of banks.
The settlement risk is bankruptcy, or inability of the counterparty for
whatever reason to complete their end of transaction. While ideally all deals
should take place in DvP (Delivery vs. Payment) mode, it is not always possible
to achieve the standard, either for want of institutional mechanism, or due to
physical barriers (such as different time zones). In foreign exchange transactions,
the time gap between Rupee settlement and FC settlement is unavoidable when
the FC settlement takes place in a different time zone (e.g. USD in New York).
The settlement risk however, is partly addressed as interbank USD deals are
now cleared through the CCIL, and only net settlement takes place with the
correspondent bank of CCIL.
The settlement risk is also present in derivative transactions. Currently
only USD/INR forward contracts are settled through CCIL. There is otherwise
a gap between trade date and settlement date, during the course of which
either of the counterparties may fail. Settlement risk, essentially, is credit risk,
different from market risk which is inherent in all treasury transactions.
It is for the above reasons that banks fix exposure limits for
counterparties, including other banks, financial institutions, mutual funds, primary
104
dealers, forex and security brokers, etc. The exposure limits are fixed on the
basis of the counterpartys net worth, market reputation, track record and / or
credit rating. The limits also take into account the size of treasurys operations,
so that the business is spread over several counterparties and there is no
concentration of risk. The limits vary in relation to the period of exposure,
whether the obligation is for overnight, 3 months or 6 months the longer the
exposure, greater is the risk and the limits are adjusted accordingly.
The exposure limits are also fixed for foreign exchange and money
market brokers, in order to avoid business concentration, even though they are
only intermediaries and are not counterparties. While the limits are generally
left to the banks discretion, Reserve Bank of India has imposed a ceiling of 5%
of total business in a year for individual brokers, subject to exceptions being
reported to the banks management for ratification. All the limits are to be
reviewed at least once in a year.
Market Risk
Market risk is the confluence of liquidity risk, currency risk and interest
rate risk. Fluctuations in equity and security prices also reflect market risk,
as the prices, in a globalised market, are influenced by currency and interest
rate requests. An integrated treasury is seized of market risk, affecting all its
operations in foreign exchange, securities and money markets.
All the free markets are highly susceptible to speculation, which in fact is
the essence of Treasurys trading positions. It is therefore perception of future
changes in interest rates and exchange rates, rather than the actual changes that
direct the market movements.
The market risks directly affect the transaction values and thereby profits
of the treasury. Additionally Treasury also plays an important part in the risk
management of the bank as a whole. Market risk translates into balance sheet
risk of the bank, and treasury is closely connected with the assetliability
management. (ALM). Treasury provides inputs to ALM and is also instrumental
in implementing the risk management solutions which we will study in later
chapters.
Quantifying the market risk therefore, is an important aspect of treasury
risk management.
Risk Measures: VaR and Duration
The movement in currency prices or security prices cannot be accurately
predicted and the uncertainty associated with their price movements gives rise
105
to price risk. At the same time the treasurer should have some idea of the
inherent risks and the way they would affect his positions. This quest for risk
solutions, led to two important measures of risk, known as value at risk and
duration.
1. Value at Risk (VaR)
VaR is a statistical measure indicating worst possible movement of a
market rate, over given period of time, under normal market conditions, at a
defined confidence level. For instance, a overnight VaR of 30 bp for USD/INR
rate at 95% confidence level implies that there is only 5% chance of the rate
worsening beyond 30 bp next day. If todays spot rate is 49.00, tomorrow the
worst possible rate for exports can be assumed to be 48.70, with reasonable
safety there is only 5% chance of the rate being worse than 48.70.
Similarly, if overnight VaR of 1-year G-Sec yield is 0.35%, current yield
of 7.75% is expected to fall/rise by not more than 0.35% by tomorrow. In the
worst-case scenario, a prospective buyer of security may therefore expect the
yields to fall to 7.75%-0.35%=7.40% by next day, while a seller of security
may expect rise in the yield to 7.75%+0.35%=8.10% by next day. At 95%
confidence level, there is only 5% possibility of adverse change being higher
than 0.35% (at 99% confidence level, there is only 1% possibility of loss being
higher than VaR).
VaR is derived from a statistical formula based on volatility of the market.
Volatility is the standard deviation from the mean of, say, USD/INR exchange
rates (or any other asset prices) observed over a period. Volatility assumes a
normal distribution curve and the number of standard deviations from the mean
denote the probability of reaching a target level. The volatility multiplied by the
number of standard deviations required for a given confidence level results in
the VaR.
There are a number of ways, with technical variations, to calculate the
VaR. Three popular approaches to VaR are: parametric approach, based on
sensitivity of various risk components. For instance, say the price of a stock
depends on its sensitivity to index changes, to interest rate changes and to
changes in the exchange rates all these components are built into a complex
formula to arrive at the VaR of the stock. The second approach is based on
Monte Carlo simulation, where a number of scenarios are generated at random
and their impact on the subject (stock price/exchange rate, etc.) is studied.
The third and more popular approach is to use historical data to arrive at the
106
probable loss. The historical data may simply be time series of data prevailing
over a period (e.g. daily USD/INR exchange rate for last 90 days), or an index
of changes (e.g. change in price over previous day). Progressive weights may
also be assigned to the data, as more recent information has greater impact on
future price movements.
While the methodology to arrive at VaR may appear to be complex, the
utility lies in that the concept is easy to understand. The Management would
like to know VaR of all risk positions, as it offers a single figure an absolute
amount a potential loss which may affect banks earnings, or, net worth. In
Treasury, VaR is used to measure potential loss, or the worst case scenario,
while holding a trading position either in foreign currency or in securities, i.e.
VaR measure can be used to assess the currency risk as well as the interest
rate and price risks. The VaR is used to measure the risk of a single investment,
or more generally, a portfolio of investments.
VaR is most commonly used to measure overnight risk, or risk over short
periods, say, over 1 month. VaR for longer periods is calculated as overnight
VaR multiplied by n (square root of n, where n is the period for which VaR is
required). However, for longer periods, VaR is not a valid measure.
2. Duration
Duration is a measure widely used in investment business, though the
concept of duration is applicable to all assets and liabilities, where interest
rate risk is present. To understand Duration, we need to be familiar with the
concept of YTM or Yield to Maturity of a bond.
Treasury invests in government securities and non-government securities
of various descriptions, viz. bills, bonds and debentures hereafter referred to
as bonds. The bonds carry a coupon rate of interest which is payable on 100%
value of the bond (par value, as at the time of issue). However, the bonds may
be traded at a discount (<`100) or at a premium (>`100), depending on the
interest rate trends in the market. The traded price is based on the market
rate of interest for residual period of the bond and is constantly changing in
the market.
The effective return on a bond (based on the coupon rate, market price
and residual maturity) is known as yield. The yield is different from interest rate
in that the yield takes into account the cash flows during the life of a bond,
including interest payments (which are normally semi-annual or annual) and
the payment of principal upon redemption. All the cash flows are discounted
107
to arrive at a present value (PV) and the rate of discount at which the present
value equals the market price of a bond is known as the yield to maturity
(YTM) or, simply, as yield on the bond. Yield is effective rate of return on
amount invested in the bond. (The YTM is calculated on the bond calculator/
built in formula in Excel/or from bond tables).
The yield is internal rate of return reflecting the ruling interest rates.
Yield and price of a bond move in inverse proportion. If the yield rises, price
of a bond falls. If the yield falls the bond price rises. It is the same relationship
between interest rates and bond prices.
Bond yields tell us the rate of return at which the present value of cash
flows equals the market price. However the YTM does not reveal how volatile
are the bond prices and how they respond to changes in interest rates. The
YTM of two bonds may be same, but the price risk associated with them may
be different on account of maturity or frequency of coupon payments. The
YTM of two bonds hence is not comparable.
Duration is a measure which helps us understand the impact of interest
rate on the price, by taking into account periodicity of coupon flows.
Duration is weighted average measure of life of a bond, where the time
of receipt of a cash flow is weighted by the present value of the cash flow. If
the first cash flow (payment of interest) is occurring after 6 months from the
date of investment, the period of 6 months is multiplied by present value of
the cash flow (0.5*PV). If the second cash flow is occurring after 12 months,
the period (1 year) is multiplied by present value of the cash flow. The present
value of final payment of interest and redemption of principal, occurring,
say, after 5 years from the date of investment is similarly used to weigh the
maturity period (5*PV). The aggregate of results so obtained is divided by the
total of weights (total of PV of each cash flow, which is also market price of
the bond) to yield Duration. It is also known as Mecaulay Duration, following
the originator of the concept, Frederick Mecaulay.
Duration is expressed in terms of years. The longer the duration, greater
is the sensitivity of bond price to changes in interest rates. The duration thus
helps compare bonds with different structures to find out which bond entails
greater interest rate risk.
The duration of a zero coupon bond is equal to its YTM, as there are
no interim cashflows, and redemption value of the bond includes interest on
the initial investment.
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To the Treasurer, duration of a bond portfolio is more important than the
duration of a single bond. The weighted average duration of a number of bonds
in the portfolio can be arrived at by adding weights to the duration of individual
bonds, the weight being the market price of the bond (expressed as a % to
the face value of the bond). If the Treasurer has a target period of holding, say
of 2 years, he can immunize his portfolio from interest rate risk by ensuring
that at any point of time the average duration of his portfolio is equal to 2. This
of course necessitates constant reshuffling of the bonds in the portfolio, as the
duration changes with lapse of time (as a bond nears its maturity).
Modified Duration (MD) is a more direct method to measure the price
sensitivity of a bond. The MD is arrived at by dividing the duration with the interest
rate (which is actually principal plus interest for 1 year, expressed as 1+Y, where Y
is the yield). If the duration of bond yielding 5% is 2.5, the MD = 2.5/(1+0.05), or
2.38. Any change in yield multiplied by MD will give the likely percentage change
in price of the bond. If the yield rises by 5 basis points, the fall in the price of the
e-bond will be 2.38*0.05 = 12 bp. Since prices move in inverse proportion to
yields, 5 bp rise in yield causes the price of bond to fall by 12 bp. The MD thus
indicates price sensitivity of a bond per unit of change in the yield levels.
There are however certain limitations in application of the concept of
duration. The modified duration is valid only for small changes in the price,
and is also not uniform at different levels of the price. A proportionate change
in prices corresponding to the change in yields is possible, only when the yield
curve is linear i.e. the short-term and long-term interest rates increase or
decrease in a fixed proportion to the term and the yield curve is a straight line
steeping upward or downward. In practice term structure of interest rates is
such that the long-term interest rates rise or fall more slowly as compared to
the short-term rates and the yield curve is rarely a straight line. For the sake
of greater accuracy, therefore, an adjustment is made to the duration measure
for convexity of the curve.
The concept of duration is equally valid for any interest earning asset,
or liability. In banks balance sheet, duration of assets (loans) and duration of
liabilities (borrowings) can be calculated to find out how sensitive are banks
earnings to changes in market rates of interest. Difference in the duration of
assets and duration of liabilities is expressed as duration gap, which is useful
for macro-hedging of balance sheet risk.
The VaR is applied to aggregate gap limits and the modified duration
measure is applied to securities, to measure the interest rate risk which
requires capital allocation under Basel norms.
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A brief note on VaR and Duration is added in the annexure to this
chapter.
Use of Derivatives in Treasury
Treasury maintains a Merchant Book (for transactions with clients), ALM
Book (for banks internal requirement) and Trading Book (treasurys proprietary
positions).
Accordingly, treasury deals in derivative instruments to cover client risks
and banks own risks, as per requirement conveyed to them.
All treasury services to clients, such as sale of forward contracts, options
and swaps, are dictated by credit limit approved by the concerned functional
departments. However, compliance with RBI requirements, particularly in
respect of suitability and appropriateness of the instruments offered will be
Treasurys exclusive responsibility. Internally, mid-office will be responsible for
monitoring the compliances.
Indian banks are permitted to maintain a book only in Rupee derivatives,
after obtaining prior approval of RBI. The book-size trading limits need to
be specifically approved by the banks Board in a documented risk management
policy. The Policy should stipulate permissible instruments for trading, maximum
positions to be held, stop-loss limits, accounting and reporting requirements
clearly. Normally treasuries maintaining positions in derivatives, will have a
dealer exclusively for trading in derivatives, which demands special skills. The
treasury should also have necessary infrastructure for pricing and valuing the
derivatives.
Derivatives are principal instruments used to bridge currency and interest
rate mismatches in ALM, which is elaborated in the following chapters.
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AnnexureI
Forward rates with overnight VaR:
09/11/2011 spot ref. 49.765
30-Nov-11 31-Dec-11 31-Jan-12 29-Feb-12 31-Mar-12 30-Apr-12 31-May-12
Forward rates 49.9050 50.1564 50.3516 50.4987 50.6524 50.7906 50.9199
ExporterWorst
Case VaR 49.5543 49.8277 50.0189 50.1930 50.3546 50.5108 50.6240
ImporterWorst
Case VaR 50.4021 50.6292 50.8166 50.9552 51.0685 51.1882 51.3079
Value-at-Risk (VaR) is maximum probable loss at given confidence level,
for a given period, under normal market conditions. VaR is generally
calculated for overnight positions i.e. maximum loss that may be suffered
next day, owing to adverse market movements. VaR is a measure of
market risk, and may be calculated for currency risk, interest rate risk or
any other price risk (e.g. commodity prices).
The rates quoted above are overnight worst-case variation in forward rates
for exporters and importers, incorporating the VaR.
Mecklai VaR tool uses Mean Variance Method, based on historical daily
close data to arrive at overnight VaR.
Simulation uses 120 daily observations i.e. around 6-month period (252
days > year). The 120th observation is the current market level.
The confidence level used for arriving at the VaR figure is 95%. The
possibility of the exchange rate being worse than the worst-case rate on
respective dates is only 5%.
In the instant case, the VaR is calculated for each of the forward points
as at the month-end (coinciding with the option expiry) from 1-month to
12-month.
To illustrate: the o/n VaR for march forward sale of USD is 30 p which
is reduced from the forward rate, to get the worst case rate of 50.3546;
while for imports, the VaR of 42 p is added to the forward rate, with
worst case rate at 51.0685. (the difference in VaR for exports and imports
is on account of bid-ask spreads).
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The VaR adjusted exchange rates are used as a prudential measure for
managing market risk.
While VaR is generally calculated for overnight (one day), VaR for
required period can be approximated by multiplying Overnight VaR with
^n (square root of n, where n is the number of days for which VaR is
required.
VaR as risk measure may be used only to indicate short-term fluctuations
in the market for terms longer than, say, 1 month, VaR may not be very
accurate.
Bond Duration
The duration of a bond security is a measure of its price and yield
relationship. The duration is the first order derivative of a price yield
relationship. We know that the price and yield are inversely related to each
other i.e. when one rises the other falls and vice versa.
Macaulay Duration
The concept of duration was first ideated by Frederick Macaulay who
was an economist and later became a pension fund manager. The Macaulay
duration by definition as weighted average maturity of a bond. The unit of
measurement of Macaulay duration is in years. It is that point in the residual
life of the bond where an investor stands to breakeven i.e. he recovers the
initial price he paid for that bond starting from today. The Macaulay duration
calculation is as given under.
Face Value 100
Market Value 99.01
Coupon 8.00%
YTM 8.25%
Frequency Annual
Maturity 5 yrs.
Macaulay Duration 4.3083 yrs.
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(A) Tenor (B) Cashflow (C) PV of Cashflows: (D) % of Market Time Weighted
(Yrs.) [(B)/(1+YTM)^(A)] Value: [(C)/ Avg: [(A)*(D)]
Mkt Value]
1 8.00 7.39 0.07464 0.07464
2 8.00 6.83 0.06895 0.13791
3 8.00 6.31 0.06370 0.19110
4 8.00 5.83 0.05884 0.23538
5 108.00 72.66 0.73386 3.66929
Total 99.01 4.3083
In the context of the above calculation is important here to note that
duration of a bond has an inverse relationship with YTM and coupon, whereas
it has direct relationship with the maturity of the bond. In case of a zero-
coupon bond the residual maturity is equal to the duration of the zero-coupon
bond. Macaulay duration is based on the assumption that changes in yield
curve are always parallel that is the yield change is the same across all tenors.
However this is not a case in the real world.
Modified Duration
Modified duration of a bond is the measurement of the price-yield
sensitivity.
Modified Duration = Macaulay Duration/(1+ YTM)
YTM 8.25%
Macaulay Duration 4.3083
Modified Duration 3.9800
PV01
PV01 is the present value of 1 basis point. Which means that change in
the current price of the bond in case the yield changes by 1 basis point. Itis
also known as the delta of a fixed income security.
PV01 = Market Value * Modified Duration * 0.01%
Market Value 99.01
Modified Duration 3.9800
PV01 0.0394
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Portfolio Duration
In case we wish to calculate the above durations (Macaulay, modified
duration & PV01) for a portfolio of bonds then we have to calculate these for
the individual bonds in the portfolio and take a market value weighted average
to arrive at the portfolio duration of the bond portfolio.
Lastly we should note that higher the duration of a bond higher is the
risk in the security.
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Asset-Liability Management
Asset-Liability Management (ALM) addresses the maturity and interest
rate mismatches that exist in the balance sheet, and hence is also referred to
as balance sheet management.
The need for ALM is generally perceived in the context of banks and
financial institutions, that is, where the mismatch between financial assets and
financial liabilities becomes significant. However, the concept of ALM is gaining
importance in corporate management also, particularly for corporates with large
treasuries. ALM is applicable not only to financial assets and liabilities, but also
to real assets which become tradable as a result of financial engineering (e.g.
securitization, sale & lease back, etc.)
We would consider the ALM in the banking context and the ALM
processes risk parameters can also be adapted to corporate environment.
Modern banking may be defined as maturity and risk intermediation, as
opposed to conventional understanding of deposit taking and lending activity.
Bank collects deposits from customers (or raise funds from the market) with
various maturities ranging from overnight to 5 years, or longer. The funds so
collected along with capital funds and call borrowings are lent to borrowers
with varying maturity requirements, ranging from an overdraft for a few days
to mortgage loans of, say 20 years. Thus the bank modifies and extends
maturities which the retail or institutional depositors themselves could not
afford to. Similarly while the depositors have assured safety of funds together
with interest, the bank does not have the same comfort while lending or
investing funds in various avenues fraught with market risk and credit risk
thus the bank also absorbs risk which individual depositors could not on their
own do.
To be more precise, the depositors and lenders of a bank plan
deployment of funds according to their own requirements, which may not
match with that of borrowing clients of the bank, and they also prefer bank
risk to the risk on the clients of the bank. Sourcing and pooling of funds and
relending of funds by way of loans and investments is only tangible part of
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CHAPTER
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banking operations. In the process the bank absorbs the risks resulting from
the mismatch, viz.
(maturity of funds borrowed from depositors/market) less (maturity of
funds lent to corporate and retail clients)
The maturity mismatch has a three-fold implication:
Liquidity: Longer maturity blocks liquidity for longer period of time, and puts
pressure on cash management.
Interest Rate: Interest rates are derived from a sovereign yield curve and they
differ from maturity to maturity thus there is no conformity between interest
rates charged on deposits and loans of differing maturities.
Currency Risk: The mismatches extend to currencies also, if the bank is
operating in a multi-currency environment. The sources and uses of funds in
different currencies (e.g. bank raising funds off-shore to fund rupee credit to
domestic companies) expose the bank to exchange risk.
While credit risk of a bank is obvious and is managed conventionally
through effective credit appraisal and supervision, what is not so obvious is the
market risk, which is manifest as liquidity risk and interest rate risk in banking
operations.
Managing Liquidity
Liquidity and interest rate are two sides of the same coin, as the
liquidity risk translates into interest rate risk, when the bank has to recycle
the deposit funds or rollover a credit on market determined terms. However
banks are extra sensitive to liquidity risks, as they cannot afford to default or
delay meeting their obligations to depositors and other lenders. Even suspicion
of pressure over a banks liquidity may prompt a run on the bank, or indeed,
threaten the very survival of the bank. Hence special attention is paid to
liquidity, in particular short-term liquidity (intra-day to one month) to ensure
funds are promptly made available when they are needed.
In the ALM process, assets yield income, hence are shown as cash
inflows, while liabilities need to be repaid, hence are shown as cash outflows.
Asset-liability mismatch is therefore, mismatch of cash flows. If part of inflow
or outflow is denominated in foreign currency, there is also currency mismatch
which needs to be managed by the Treasury.
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Liquidity implies a positive cash flow, i.e. cash inflows being in excess
of cash outflows in a given time period. Liquidity results from not only cash
surpluses of the bank, but also from other sources where cash can be readily
drawn, such as committed credit lines from other banks, liquefiable securities
and nostro balances. The available cash resources are compared with immediate
liabilities of the bank in the given time range and the net liquidity is worked
out. In different time bands, the loans falling due for repayment constitute main
source of funds, while the deposits and other obligations maturing during the
same time band constitute uses of funds. (In both cases interest flows are also
considered as and when they arise.) The difference between sources and uses
of funds in specific time bands is known as liquidity gap which may be positive
or negative. The liquidity gap arises out of mismatch of assets and liabilities of
the bank.
RBI has prescribed time bands (1 to 14 days, 14 to 29 days, 1 month
to 3 months, etc.) for measuring and monitoring liquidity gaps. ALM process
involves plotting of assets and liabilities maturity wise in time buckets and
measuring the gap between assets and liabilities maturing in a specific time
period. Liquidity risk is reflected as maturity mismatch which is the gap in
cash inflow and outflow. The risk is not being able to find enough cash, or cash
at acceptable rate of interest, to fund the gap.
Liquidity risk will also arise if the liquidity in market dries up and the
bank is not able to dispose of its liquid securities without suffering a loss, or
if the liquefiable securities suddenly become illiquid. The Bank should hence
take into account, the marketability of securities, while classifying them as liquid
instruments in the nearest time buckets.
RBI from time to time issues detailed guidelines for managing ALM
risks. RBI is more particular about short-term liquidity, ranging from intra-day
to one month. Current guidelines stipulate that the net cumulative negative
mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets
should not exceed 5%, 10%, 15% and 20% of the cumulative cash outflows
in the respective time buckets. Banks are required to provide in their
Liquidity Management Policy, contingency measures to meet any shortfall in
liquidity.
While the RBI stipulates minimum liquidity levels, banks need to find their
own comfort in maintaining adequate liquidity, in particular, intra-day liquidity,
to meet their payment obligations under Real Time Gross Payments System
(RTGS).
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Liquidity of a bank may also be affected by external factors, not under
control of the bank. Global liquidity in interbank markets dried up during 2008-
09, owing to the contagion effect of sub-prime mortgage crisis in US markets.
More recently, global banks, in particular, European banks faced liquidity
problems resulting from sovereign debt crisis which also impacted domestic
lending of Indian banks. When global liquidity dries up, the credit lines extended
to banks also get frozen and banks tend to depend on call and notice money,
with pressure on short-term interest rates.
Measuring liquidity mismatches
Liquidity is measured by what is known as the gap method.
The assets (cash inflows) and the liabilities (cash outflows) are distributed
in time buckets, based on their actual / estimated due dates. The time buckets
are for narrower periods in the beginning, widening gradually up to 1 year.
(1-3 days, 4-7 days, 8-14 days, 15-28 days, 1 month-3 months, 4-6 months
and 6-12 months). The liquidity gap is the gap between cash inflows and cash
outflows, generally measured as a % of the cash outflows. The gap in individual
time buckets is more important than the cumulative gap for the whole period.
Apart from the regulatory prescription, banks may stipulate their own
prudential limits on negative gaps in liquidity. Banks may also limit the positive
liquidity gaps (cash inflows in excess of outflows), in order to save on the cost
of liquidity.
The cost of liquidity may be calculated using average cost of deposit
funds, or, more accurately, applying money market rates of interest to the funds
in excess of cash outflows in each of the time buckets.
Liquidity gaps need not be measured beyond 1 year, as the liquidity gaps
in the longer period are best reflected in interest rate mismatches.
Contingency measures that the bank may put in place to manage
liquidity risk include the following:
Stand-by credit lines fully committed facilities from correspondent
banks. Generally such facilities are taken on reciprocal basis. Bank should
exercise care that the facility is not subject to availability of funds even if a
committed facility involves payment of commitment charges.
Investment in liquefiable securities in order to minimize cost of
liquidity, the bank may invest funds in short-term securities or securities that
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have a liquid market. Such securities include T-bills, commercial paper, liquid
mutual fund units, PSU bonds and AAA-rated corporate securities. While the
bank may earn a reasonable return on securities, it must be realized that any
distress sale of securities might result in loss of principal amount.
Excess holding of SLR securities banks generally hold eligible
securities, mainly central government bonds (G-sec) in excess of the minimum
requirement of 25% of DTL (demand and term liabilities). The excess securities
help the bank to borrow under overnight/intra-day repo facility of RBI. The
securities are also highly liquid and those which are held for trading, provide
ready liquidity to the bank. The securities would also help banks borrow under
CBLO facility.
Other measures would include sound liquidity planning preceded by a
study of seasonal/cyclical demand for funds, behaviour of deposit customers and
pooling of cash resources from branches.
Interest Rate Risk
Interest rate risk arises when interest earnings are not adequate to set
off interest payments due in a given period, even if the book value of the asset
equals that of the liability, owing to a change in market rates of interest.
Net interest income (NII) of the bank is the difference between interest
earnings and interest payments in a given accounting period. Hence interest
rate risk may be defined as the risk of erosion of NII, on account of interest
rate movements in the market.
In a hypothetical situation, assume that the Bank has mobilized deposits
of ` 100 cr., with average maturity of 6 months, at 7% interest. Also assume
that the bank invested the amount in a fixed interest loan payable after 5 years
at 9% p.a. the NII is a clear 2% or ` 2 cr. per year.
The deposits mature after 6 months and need to be replaced or recycled
at current market rate, say, at 8% as interest rates have risen by that time.
The interest on loan continues to be 7%, hence NII for second half of the year
is reduced by 1%. If we assume that the deposits become even costlier after
next 6 months, demanding renewal at market rate of say, 9%, the NII is totally
eroded. However, if deposit rates fall by 2%, the NII correspondingly rises for
the specific period.
In a reverse situation, a deposit for 3 years may have a fixed interest,
while the deposit funds are deployed in trade finance, say, in discounting
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3-month usance bills, to start with, with a positive spread. If the interest rates
fall, subsequent discounting of bills may earn lower rate of interest, in line with
market rates, while cost of deposit remains fixed, thereby adversely impacting
the NII.
The risk of erosion of NII is on account of deposit rates being floating
(repriced every 6 months), while the loan interest is fixed (repriced only after
5 years when the funds are available for fresh lending, on repayment of the
loan), or vice versa. The interest rate mismatch is therefore also known as
repricing risk.
Repricing risk exists where, in a given time bucket, say 6 months to
1 year, the assets and liabilities which are due for repricing are not equal. A
tier-2 bond maturing after 7 years with fixed interest rate of 7%, is not due
for repricing during 6 m 1 yr time bucket, hence is not sensitive to changes
in market price. However a loan, funded from the bond issue, getting repaid
during 6-12 month period is due for repricing, as fresh lending can take place
only at market rates. The bond amount (liability) appears in the 5-7 year time
bucket, while the loan amount (asset) appears in the 6 m 1 yr time bucket,
revealing a interest rate mismatch in both cases.
Measuring the interest rate sensitivity (IRS) gap
For the purpose of ALM, all assets and liabilities are placed in time
buckets, based on their repricing dates (i.e. when the interest rate is due for a
change). The mismatch in each time bucket is measured as a gap between rate
sensitive assets and rate sensitive liabilities. The mismatch may be measured
either in absolute amounts, or as sensitivity ratio, or as a % of rate sensitive
assets to rate sensitive liabilities. The mismatch presents a risk to the NII,
hence is to be monitored regularly, with pre-set limits.
The IRS can be measured more accurately using present value method or
by calculating earnings-at-risk. Present value is arrived at by discounting the IRS
mismatches in each time bucket by applicable market rate of interest. Present
value so arrived indicates the amount to be lent or to be borrowed today to
mature in the respective time buckets, so as to bridge the mismatches.
Under the earnings method, interest on the mismatches is calculated at
applicable money market rates. The worst case change in the interest rate for a
given period is indicated by VaR (value-at-risk) which is a statistical method to
calculate the worst case, based on historical data, at a given level of confidence
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(usually at 95%) under normal market conditions. The VaR adjusted earnings
provide earnings-at-risk or the likely impact on net interest income, if there is
an adverse movement of interest rates.
A stress test on net interest income may also be conducted under
different interest rate scenarios to assess the impact of mismatches, and also
to test the adequacy of capital to support contingent losses. Basel 2 norms
recommends sensitivity to a 200 basis points parallel shift in yield curve as a
standard measure. Banks may however stipulate their own parameters, based
on current market conditions, to formulate the interest rate scenarios.
Duration is a refined method of assessing interest rate sensitivity, taking
into account the time value of cash inflows and cash outflows. Duration
calculates present value of cashflows after weighing them with respective time
periods. Modified duration measures the impact on interest income if the
interest rate varies by 1% (or 1 bp) on either side. Duration is to be calculated
for assets and liabilities separately and a limit on duration gap automatically
limits the maturity mismatches in respective time buckets.
Interest Rate Risk Management
The bank should lay down tolerance levels for mismatch in each of the
time buckets.
If the tolerance level is breached, interest rate sensitivity gaps in each of
the time buckets can be bridged in two ways. Incremental assets and liabilities
can be moved into or away from the specific time buckets in order to bring
down the mismatches. For instance, if the liabilities getting repriced in the
time bucket of 3-5 years exceed assets falling in the same time bucket, credit
department should prefer to extend new loans which get repriced or mature
in the 3-5 year time bucket so as to reduce the mismatch. This amounts to
physical adjustment of asset-liability portfolio.
Alternatively, if the IRS mismatches are persisting in specific time buckets,
interest rate derivatives can be used to rebalance the asset-liability portfolio.
For instance, assume that loans with fixed interest have average tenor of 5
years, and are funded by deposits with average maturity of 6 months. The fixed
interest on loans may be swapped into 6-month floating rate, say T-bill rate, in
order to reduce the mismatch. The interest rate swap effectively reprices the
loan every 3 months, on par with the 6-month deposits. There could be a small
basis risk if the short-term deposit rates do not exactly move corresponding to
the movements in T-bill rates.
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The bank loans are generally priced over the base rate of the bank, hence
all loans, including term loans are considered to be on floating rate basis. As the
banks base rate (cost of funds) is generally impacted by the G-sec yields, a G-sec
based swap would also help reduce the mismatches. For instance, a 6-month
deposit rate linked to T-bill rate may be swapped to 5-year G-sec rate, thereby
reducing the IRS mismatch in the 6 m to 1 year time bucket.
It is also possible to hedge the duration gap of the balance sheet, in what
is known as macro hedging. The duration of assets and duration of liabilities on
the balance sheet is calculated separately and the gap in duration is hedged by
using interest rate swaps (or other derivatives) to swap floating into fixed or
fixed in to floating rate of interest. The hedge needs to be managed dynamically
as the duration gap of the balance sheet keeps on changing. However, duration
is an appropriate measure only if the assets and liabilities are tradable, or have
a definite market value.
Rational pricing of deposit and loan products benchmarked to a risk free
interest rate will also help bring down the IRS mismatches.
Resource mobilization needs to be planned in such a way that the capital
adequacy ratio is always maintained, even after considering committed loans,
yet to be drawn.
Currency Mismatches
Currency mismatches arise when the bank raises funds overseas to fund
domestic operations, or use domestic resources for investment in overseas
branches. In either case the exchange risk is to be managed using currency
and interest rate derivatives, as elaborated in Treasury Risk Management in the
earlier section.
Currency mismatches are also generated in the merchant business while
selling or buying forward contracts to customers. Treasurys proprietary trading
also generates currency mismatches. RBI monitors the currency mismatches
by approving gap limits and daily position limits, which banks are required to
monitor meticulously.
Crisis Management
A liquidity crisis or a persistent interest rate mismatch in specific time
buckets, would warrant a corrective action by the Bank. Some of the
immediate measures that a bank can initiate, include:
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Freezing expansion of credit in specific sectors or for specific maturities
Providing incentives/dis-incentives for delayed drawdown of approved loans
Converting funded facilities into non-funded facilities (which would save
liquidity)
Investing in securities with put or call options to modify the maturity of
the debt, and
Structuring the loan products with rollover options/sculpted interest rate
payments to ensure that mismatches are not concentrated in only a few
time buckets.
RBI stipulates capital adequacy requirement for market risk, which
includes interest rate mismatches. Capital is also to be provided for any
derivatives (forwards, options and swaps) used to bridge such mismatches. RBI
is recommending simplified approach under Basel 2, (which is being upgraded
to Basel 3 norms) for determining the capital requirement for derivative
instruments.
ALM set-up in banks
The ALM function is supervised in banks by Asset Liability Management
Committee (ALCO) which is chaired by the Chairman or an Executive
Director of the Bank. ALCO is appointed by the Board and is responsible
for implementation of the ALM Policy. Members of ALCO include senior
executives of the bank, responsible for planning, resource mobilization. credit
approvals, international business and treasury, so as to achieve co-ordination of
all functional departments in implementation of ALCO decisions. ALCO is also
responsible for product pricing, i.e. pricing of deposit and loan products for
various maturities, which has a direct impact on the ALM risks.
ALCO is supported by ALCO Support Group, who would provide
analytical data to facilitate ALCO decisions, and would take care of all
operational aspects in implementing the decisions. ALCO support Group is
generally part of Mid Office or Back Office of Treasury.
Role of Treasury in ALM
As stated earlier, the core function of Treasury is fund management. It
automatically engulfs liquidity and interest rate risks, as the treasury maintains
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the pool of banks funds. We may briefly explain the relationship between
Treasury and ALM as under:
The balance sheet of a bank carries enormous market risk (in addition
to credit risk), but the banking operation itself is confined to accepting
deposits, and extending credit to needy borrowers, besides miscellaneous
payment services. It is Treasury which operates in financial markets
directly, establishing a link between core banking functions and market
operations. Hence the market risk is identified and monitored through
Treasury.
The asset-liability mismatches cannot be ironed out as the assets or
liabilities cannot be physically moved across the time bands. The bank
earns profits out of mismatches and it is not really advisable to remove the
mismatches completely from the balance sheet. Treasury uses derivatives
and other means, including new product structures to bridge the liquidity
and rate sensitivity gaps, so as to make them fall within the pre-set
tolerance level.
Treasury, while taking trading positions in forex and securities markets, is
also exposed to market risk of its own creation. Sometimes the risks are
compensatory in nature and help bridge the mismatches on banking side.
The Treasury may therefore hedge only residual risk.
As the markets develop, many credit products are being substituted
by treasury products. For instance, bank may subscribe to commercial
purpose, instead of extending working capital to an entity. Bank may
also securitise specific loan portfolios, say, mortgage loans or credit card
receivables which become tradable in the market. Treasury products are
marketable and hence liquidity can be infused in times of need. Treasury
also monitors exchange rate and interest rate movements in the markets,
and hence it is much easier to administer such risks through treasury
operations.
It is for the above reasons that operations relating to market risk
management have become an integral part of treasury. In many banks,
either ALM desk is part of dealing room, or, ALCO support group is part of
treasury team. The Treasury head is always an important member of ALCO,
contributing not only to risk management but also to product pricing and
other policy issues.
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Credit Risk and Credit Derivatives
Credit risk is conventionally managed by credit departments of the
bank with elaborate systems for credit appraisal, internal credit ratings, credit
approval and credit monitoring.,
Treasury and Credit Risk
While Treasury is mostly concerned with market risk, there are ways in
which Treasury may get intertwined with banking operations in the credit area.
Integrated treasury includes investment function and deals with debt-market
products, such as commercial paper and bonds, which are credit substitutes.
Highly rated companies prefer issue of debt paper to bank credit, as cost of
credit (interest rate) is relatively lower in the debt market where in addition
to banks, there are other investors (insurance companies, mutual funds, etc.)
who may invest in debt instruments. Instead of lending to a company, the bank
may also prefer to invest in corporate bonds through the Treasury. While credit
risk in a loan and bond is similar, unlike a loan, bond is tradable and hence is a
more liquid asset. The bank has an easy exit in that the bond can be sold at a
discount if the credit status of the issuer deteriorates. While a loan is normally
with a fixed rate of interest or interest linked to base rate of the bank, the
bond is priced in the market on the basis of credit quality and interest rate
movements hence, the bond can be marked-to-market as frequently as
required, for assessing potential gain/or loss. The non-SLR investment portfolio
of treasury, which supplements banks credit portfolio, is therefore more flexible
and ideal from ALM point of view, as the Treasury can manipulate the maturity
and yield levels of the investment assets more easily to manage the asset-liability
mismatches.
There are also new products which convert conventional credit into
tradable treasury assets. The process is called securitisation, whereby assets
like fixed loans or credit receivables of the bank, can be converted into units
or bonds (often called pass-through certificates PTCs) that can be traded
in the market. Securitisation infuses liquidity into the issuing bank, and frees
capital blocked in such assets for fresh lending. Banks with surplus funds can
also invest in such PTCs, through their Treasury, as a means to expand their
credit portfolio indirectly.
Credit Derivatives Credit Default Swaps (CDS)
Credit derivatives have come into vogue only in the last 10 years. Credit
derivatives segregate credit risk from loan/investment assets. The instruments,
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known as credit default swap or credit linked certificate transfer the credit risk
from owner of the asset to another person who is in a position to absorb the
credit risk, for a fee. There is a protection buyer, say a bank, a protection seller
who may be another bank, financial institution or an investor, and a reference
asset which may be a large corporate loan or a bond or any other debt
obligation. The protection seller guarantees payment of principal or interest or
both, of the reference asset owned by the protection buyer, in case of credit
default (or, a credit event defined in the contract). In consideration of the
protection, the protection buyer pays a premium (akin to a guarantee fee) to
the protection seller.
Credit derivatives (CD) help the issuer diversify the credit risk and use
the capital more efficiently. The CD is a transferable instrument, though the
market for CDs is not very liquid. The CD products are still emerging and
various covenants related to the transaction are incorporated in the ISDA
Master Agreement for Credit Derivatives.
The global financial crisis (2008-09) brought out some negative aspects
of credit derivatives, which in fact, aggravated the crisis. Following two aspects
have been of prime concern to the regulators as well as market payers:
Banks and investment institutions (in particular, in US, UK and Europe)
have rather been negligent in assessing the credit quality of the assets,
as they could securitise the assets as soon as they are acquired, or
transfer the credit risk to a third party who would sell them credit default
protection (by issuing credit default notes or credit linked notes) for a
small fee. The protection however is not perfect, as there is a counter
party risk (the credit status of protection provider), which replaces the
underlying credit risk of the loan. The lending bank (or the institution
originating the loan) also needs to provide credit enhancement, by
retaining part of the underlying risk. During the crisis period, credit quality
of the assets (mainly home loan mortgages) as well as credit status of the
protection providers deteriorated very fast, threatening the survival of
some large commercial and investment banks. Finally the governments/
central banks had to come to rescue by lending against weak assets
(troubled assets) to infuse liquidity and support shrinking capital of the
banks.
Credit Derivatives are highly leveraged as the protection fee or the credit
default spread is a tiny portion of notional value of the underlying credit.
As there is no initial investment, credit derivatives are highly profitable
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so long as credit default does not take place. Trading in credit derivatives
became very active, particularly as some of the investment institutions
and fund managers created credit default swaps based on synthetic assets
(virtually, without underlying credit). Once the mortgage crisis hit the
underlying credit market, the protection value offered by these institutions
almost disappeared, further spreading the crisis to protection sellers like
investment banks and insurance companies. This necessitated huge bailouts
from governments, as the entire financial system was at risk if some of
these large institutions were to go into bankruptcy.
For the above reasons, Reserve Bank of India has been very cautious in
introducing credit derivatives in India. After several discussions, based on draft
guidelines, RBI cleared introduction of CDS in Indian markets only recently. The
CDS market formally opened up on 2nd of December 2011. A brief write up
on the CDS market appears in the annexure to this section.
Transfer Pricing
Transfer pricing is an integral function of asset-liability management and
is in the domain of banks treasury. Transfer pricing refers to fixing the cost of
resources and return on assets of the bank in a rational manner. The treasury
notionally buys and sells the deposits and loans of the bank, and the price at
which the treasury buys and sells forms the basis for assessing profitability
of banking activity. The treasury determines the buy/sell prices on the basis
of market rates of interest, the cost of hedging market risk and the cost of
maintaining reserve assets of the bank. For instance, the banking department
may procure a deposit at 7% but the treasury buys the deposit only at its
market cost, after adjusting to hedging and liquidity, say at 6% the difference
being the cost exclusively borne by the banking department. Similarly the
bank may lend at 10% and sell the loan to Treasury at transfer cost, say, 8%
the balance being risk premium earned by the banking section. The prices
vary according to the tenor/maturity of the loan/deposit. There are of course
different ways of arriving at transfer pricing and the bank has to formulate a
conscious policy in this regard.
Once transfer pricing is implemented, treasury takes care of the liquidity
and interest rate risks of the entire bank, and profits of credit department
reflect only the credit risk, net of all mismatches of sources and uses of funds.
In a multi-branch environment, transfer pricing is particularly useful to assess
the branch profitability.
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Policy Environment
The asset-liability management will be effective, only if there is a strong
policy foundation. The ALM Policy, as a minimum, will have the following
components:
Setting up ALCO and ALCO Support Group, frequency of ALCO
meetings, etc.
Measuring the Liquidity and Interest Rate mismatches
Setting tolerance levels for mismatches
Managing mismatches defining policy initiatives, product pricing and
resource mobilization, achieving co-ordination between functional
departments and ALCO
Use of derivatives to contain the mismatches: Policy to specify permitted
instruments
Crisis management in abnormal market conditions
Infrastructure system requirement for ALM, use of ALM models, etc.
Compliance with regulatory requirements and
MIS for top management
Though in general we describe it as ALM Policy, the policy should aim at
aggregate risk of the bank and all other risk management policies of the bank
should be consistent with the risk parameters of ALM Policy. Some of the bank
policies on which ALM will have a bearing include investment policy, foreign
exchange risk management policy and policy for use of currency and interest
rate derivatives.
It is advisable that the bank would evolve a composite risk management
policy to achieve policy co-ordination and functional co-ordination in the
implementation sphere.
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AnnexureI
Credit Default Swaps in India
RBI has released final guidelines for Credit Default Swaps in corporate
bonds on 23rd May, 2011 . The rupee denominated CDS market was to kick
off as soon as the guidelines become effective from 24th October, 2011
however RBI deferred the date to 1st December, 2011.
CDS Global Perspective
In the global financial markets especially the G-10 markets (US, Euro
zone, UK, Japan & Canada) the CDS market was the fastest growing derivatives
market before the sub-prime crisis. However during the recent crisis in global
markets (2007-09) the CDS market was blamed for the financial turmoil, in
particular, for the near bankruptcy of the leading insurance group AIG Inc. and
consequent increase in credit spreads and margin requirement affecting the
investment banks. The outstanding notional of the CDS trades worldwide was
seen to be much higher than the actual underlying corporate debt and the high
leverage was direct cause of collapse of CDS market. RBI guidelines therefore
attempt to minimize the risk of speculative trading in Indian CDS.
Some of the notable features of the CDS product traded globally are:
The bulk CDS products which are traded worldwide are single entity CDS
i.e a CDS on corporate underlyings like IBM, Wells Fargo & Co, Merrill
Lynch & Co., Volkswagen AG, Daimler AG, Mitsubishi UFJ Financial, etc.
The single entity CDS trades on sovereign debts like Kingdom of Spain,
Federative Republic of Brazil, Hellenic Republic (Greece), Czech Republic,
Emirate of Abu Dhabi, etc. are also very common.
Apart from the single entity exposures, CDS on indexes are also widely
traded. Some of the prominent CDS indices are MarkIt Itraxx and CDX.
The credit default swaptions market is also active on the CDS index
underlyings.
The CDS indexes market is active for both Investment Grade issuances as
well as High Yield (Junk grade) issuances.
CDS market for other illiquid underlyings like loans; mortgages like ABS,
MBS, pools & TBAs (To Be Announced) also exists.
All the major investment banks like Goldman, Deutsche, JP Morgan,
Barclays, BNP Paribas, etc. are market makers in the CDS market. The
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investor/ trader segments include most of the financial entities like hedge
funds, commercial banks, pension funds, mutual funds, mortgage houses,
insurance companies, etc.
MarkIt is the leading provider for the data on CDS markets and the widely
used valuation model for CDS is the JP Morgan model.
Despite the criticism faced by the CDS worldwide, it is still reckoned as
one of the key financial innovations which can be used wisely to transfer credit
risk. Primary objective of RBI for introducing the CDS in the Indian market is
to provide market participants a tool to transfer and manage credit risk in an
effective manner through redistribution of risk. At the same time RBI has taken
precautions to avoid excessive use of CDS only to derive trading profits.
CDS The India Story
USD denominated CDS market on Indian entities is already active in
the financial markets of countries like US, UK and Singapore. Few of the
prominent Indian CDS entities are ICICI, Tisco, Reliance Industries, Exim Bank
& IDBI bank. Indian entities are also a part of the CDS indexes market, being
a component of MarkIt Itraxx index like MarkIt Itraxx Asia Ex-Japan. A lot
of equity market participants do track the movements in the CDS spreads of
these Indian entities.
RBI had earlier published the CDS draft guidelines in 2007 and was
looking forward to introduce the CDS in Indian markets the following year.
However the decision was held back as the global financial markets were
hit by a severe recession which also led to a major credit crunch. Credit
derivatives market faced severe criticism by various sections like financial
market regulators, academicians, market participants and most importantly by
political leaders in the developed countries. The world then witnessed a series
of events like bankruptcy of Lehman Brothers; sell off of Merrill Lynch and
bailout packages handed out to leading banks like Citigroup, Goldman Sachs,
Bank of America and AIG.
One of the key intentions of RBI in introducing the CDS in India is
to develop the underlying corporate bond markets, especially that of the
infrastructure financing. By introducing the CDS the RBI wants to develop an
avenue wherein the infrastructure financiers can transfer the risk. Currently
the secondary corporate bond market lacks depth with an average daily traded
volume of around ` 200 cr as against annual primary market issuance of around
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` 1.60 lakh crores. Investors (mostly banks, pension funds and insurance
companies) being highly risk-sensitive, the secondary market for issuances rated
below AA is non-existent. The issues like stamp duty and long shut periods
(record dates during book closures in which bonds arent traded) have plagued
the corporate bond market since a longtime.
Other RBI measures to promote debt market include permitting Repo
in corporate bonds and interest rate futures. For various reasons both the
measures failed to bring in momentum to the debt market. CDS hence
provides fresh hope to provide required comfort to potential investors.
RBIs Guidelines on CDS
RBI has allowed the FIIs to trade in the CDS market which is a good move
in order to ensure the success of the market. Availability of instruments to
hedge credit risk would encourage FII interest in corporate bonds further.
RBI has permitted commercial banks, PDs, Mutual Funds, Insurance Cos,
Housing Finance Cos, PFs and listed corporates and thus ensured that all
the debt market participants are given an opportunity to hedge their credit
risk.
RBI after consultation with the State run banks amended the earlier
requirement for market maker wherein the minimum capital to risk
weighted assets ratio was relaxed by 1% to 11% and also the core Tier
1 CRAR was relaxed by 1% to 7%.
In response to the global criticism of CDS the RBI has made sure not to
permit CDS on illiquid underlyings like ABS, MBS, convertible bonds, etc.
CDS is also not allowed to be part of any other structured offering.
FIMMDA would set market standards for CDS valuation and would also, as
directed by the RBI, publish the CDS spreads curve. FIMMDA & RBI need
to pay more attention to this area as the CDS valuation is very complex;
with kind of spreads/default probabilities to be used and the recovery rates
to be used, lien/seniority of the underlying bond, etc.
Overall the introduction of CDS is perceived as a positive step for
development of financial markets in India. As the underlying corporate bond
market is not very vibrant, market players need time to appreciate the benefits
of CDS. RBI and FIMMDA should help establish prudential market practices
with required flexibility, in order to help evolve a liquid market for CDS.
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The final CDS guidelines have become effective from 1st Dec, 2011. The
first deals were struck by ICICI bank & IDBI bank on Wednesday 7th Dec
2011. The reference entities were Rural Electrification Corp (REC) & Indian
Railway Finance Co (IRFC). The notional, contracted spread and tenor for both
the trades were similar at ` 5 cr, 90 bps and 1-yr respectively.
mmm
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Global Financial Markets
The movement of capital across the borders take place in global markets
in two ways: equity and debt. There is also quasi-equity (or quasi-debt) which
has the characteristics of equity as well as debt, e.g. optionally convertible
bonds (option to convert debt into equity) and perpetual bonds (debt which is
not repayable, but bears a coupon rate of interest). The securitized debt forms
equity of a special purpose vehicle (SPV), essentially adding equity risk to debt
originated by the parent company.
The umpteen ways of combining debt and equity, with added features
of convertibility options, callable and puttable debt, has given rise to structured
financial solutions, broadly referred to as financial engineering in the global
financial markets.
Principal features of global financial markets are:
Capital flows are denominated in free currencies (which are not subject
to domestic exchange control regulations), such as USD, GBP, Euro, CHF
and JPY.
Global market exists across national markets where there are minimum
regulatory restrictions while there may be restriction on inflow of capital
in varying degrees (as in the case of emerging market countries), there
must always be assured repatriation of capital by means of redemption of
debt or equity.
Global markets are largely free of regulation there is no global regulator
and are subjected to self-discipline best market practices evolve from
self-regulatory organizations (industry associations like ISDA & ISMA) and
inter-institutional agreements between major market players.
Capital flows may also take place in currencies which are not fully
convertible, based on bi-lateral or multi-lateral agreements between countries
however such capital flows hardly constitute a global market.
Technically, global markets are regulation-free however, domestic
regulations in major markets such as proposed restrictions on derivatives
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CHAPTER
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in US and Europe or taxation on global income, do affect the nature of
transaction in global market.
Subject to some exceptions, global markets are otherwise free markets,
where there is no single dominant player, and the exchange rates and interest
rates are determined by market forces. The increasing focus on market risk
management is therefore, a direct result of globalization of domestic markets.
Global debt outstanding over last 3 periods, and Indias share therein
(representing FC market borrowings of Indian entities) is presented below, to
obtain a perspective on the size of the market.
(USD bn)
Dec-09 Dec-10 Sept-11
International Debt Securities O/S 26,995 27,668 29,775
Indian Debt securities O/S 30.50 28.50 27.70
External Commercial borrowings of
Indian entities (total debt) 21.669 25.776 20.776
In the Indian context, despite Rupee continuing to be partly convertible,
the progressive liberalization of economic policy has permitted large-scale capital
flows, both short-term and long-term, across the sectors. The capital flows
mainly take place in one or more of the following categories.
Portfolio Investment refers to investment in secondary market for equity
and debt currently confined to foreign institutional investors (FII)
registered with SEBI (apart from NRI investors).
Foreign direct investment (FDI) takes place by means of investment in
equity and external commercial borrowings of Indian entities.
Capital outflows largely result from overseas direct investment (ODI) by
Indian corporates, either by expansion into overseas markets or acquisition
of offshore units. Miscellaneous remittances include payment for financial
and technical services, dividends and returns on foreign investment in India.
Resource Mobilisation in global markets
Domestic companies tend to raise equity and debt in global markets for
various reasons, including the following advantages.
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Cost considerations
Foreign debt is at times cheaper than domestic credit, on account of
interest rate differentials. Interest rate advantage is however balanced by the
cost of hedging currency risk. More importantly, given the same credit rating,
credit premium in global markets tend to be lower, owing to the markets being
much larger and more appreciative of credit risks. Speculative tendencies, in
anticipation of falling interest rates or appreciating domestic currency also play
a part in preferring foreign debt to domestic debt.
Currency matching
Equity or debt is mobilized in foreign currency in order to meet
outflows in the same currency, say, for overseas investment, for acquisitions
or for payment of project imports. A USD loan to meet imports billed in
USD is more economical than a JPY loan, even if the latter carries lower rate
of interest. Long-term currency mismatches need to be avoided to minimize
hedging costs. For instance, an airlines company may prefer a yen loan, if a
major part of its revenue is accruing in yen from the Japan sector.
Diversification
If the size of equity or debt funds to be mobilized is relatively large, the
issuer may prefer to approach global markets to diversify the investor base. The
investors across the markets absorb large issues (which may not be common in
domestic markets), help bring down the cost of funds, and also facilitate recycling
of debt, or reissue of equity, if the performance is found to be satisfactory.
Risk Management
Managing market risk in global markets is often found to be easier,
as appropriate instruments, OTC as well as exchange traded products, are
available. The markets being deep and highly liquid, the pricing will also be
fairer. In India, paradoxically, it is much more difficult to hedge PLR-linked
interest rate risk, than hedging LIBOR-linked foreign currency debt.
We may briefly review the instruments generally used in the global
markets, with particular reference to Indian corporates.
Equity Issues
Indian companies can issue equity in foreign currency by means of issue
of American Depository Receipts (ADR) or Global Depository Receipts
in overseas markets.
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A depository receipt is a negotiable instruments representing a specified
number of shares deposited with a bank or a depository institution, and is
generally listed on a stock exchange.
An Indian company wishing to raise dollar resources in US markets may
issue ADRs. ADR represents shares of a non-US company deposited with a US
institution. ADR is denominated in USD and the traded price of ADR closely
resembles issuers domestic stock price. The ADRs are sponsored at 3 levels
at the lowest level the ADR can only be traded in OTC market, with minimum
reporting requirements to Securities Exchange Commission of USA. Level 2
issues are to be registered with SEC and is subject to its regulation. Level 3
issues are subjected to stricter rules of SEC and or on par with domestic issues
of US companies. ADRs of level 2 & 3 can be listed and traded on all American
exchanges.
Indian companies can also issue equity in foreign currencies in non-US
markets by means of Global Depository Receipts (GDRs). GDR represents
specified number of shares (usually 10) of a foreign issuer with a global depository
bank/institution. Indian companys shares are deposited with global banks like JP
Morgan Chase or Citibank, and the GDRs are issued to investors worldwide (but
not in domestic markets unless it complies with local regulations). The GDRs
are listed and traded on global stock exchanges like London Stock Exchange,
Luxemburg Stock Exchange and Singapore Stock Exchange.
Under revised regulations of SEBI (Sept., 1999), the ADR / GDR holders
are entitled to exercise their voting rights, subject to terms of the issue so
permitting. The GDR / ADR holdings are also subject to sector-wise caps on
FDI, as per the FDI policy of Government of India. Certain fungibility of the
depository receipts with domestic shares is permitted, restoring the eligibility
to further issue the depository receipts within the ceiling. Latest RBI guidelines
on foreign investment in India need to be referred to for details.
It may be noted that foreign investment in ADR/GDR is distinct from FII
investment in portfolio or other foreign direct investment in Indian companies
(say, by private equity funds), in-as-much as the latter is in Indian rupees on par
with Indian equity holders and fully subject to SEBI regulations.
Several Indian companies have issued ADRs and GDRs which are actively
traded in global exchanges. Prominent issuers include Dr. Reddy Labs, HDFC
Bank, L&T, Tata Motors and MTNL.
Typically, the depository receipts are issued on private placement basis.
The process of issue of ADRs and GDRs include
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Appointment of investment brokers
Finalization of Prospectus with terms of issue
Registration with local regulator (in case of ADR)
Agreement with depository Institution
Road shows to attract qualified investors, and
Allotment and listing on stock exchanges
Indian Depository Receipts (IDR)
IDRs facilitate capital flows in the opposite direction, that is, overseas
companies mobilizing equity funds in Indian market. Government of India,
Ministry of Company Affairs (MCA) provided necessary framework for issue
of IDRs by foreign companies. Subsequent guidelines issued by SEBI and RBI
pertain to procedural and listing arrangements. MCA has also laid down norms
for eligible issuers in terms of minimum capital, market capitalization and
continuous track record.
Minimum issue size of IDR is prescribed as USD 500 mn. The actual
issue of IDRs take place by Indian depository institution, against the underlying
deposit of shares of the foreign company mobilizing the equity. The IDRs are
to be listed and traded in Indian stock exchanges.
The issuer company (unless it is in financial sector) does not require
prior approval of any sectoral regulator for issue of IDRs, once it is qualified
under MCA norm. Foreign banks and financial institutions having a presence in
India, however, require prior approval of RBI for issue of IDRs.
All the Indian companies and institutional investors qualified for overseas
direct investment (ODI), FIIs and individuals under liberalized remittance
scheme of RBI can invest in IDRs.
So far Standard Chartered Bank is the only issuer of IDR, having issued
IDRs of USD 500 mn in 2011 (fully subscribed).
Debt Issues
Mobilization of foreign currency funds may take place by loan syndication
or issue of global debt securities in India, RBI regulations pertaining to external
commercial borrowings (ECB) cover foreign currency loans from off-shore
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lenders, global bonds including foreign currency convertible bonds, and
preference shares without mandatory convertible option. RBI also regulates
short-term trade debt which cannot exceed 1 year, except in case of capital
goods imports, where the credit terms may extend to 3 years.
A debt issue in global markets is generally preferred when the issue size
is large and the issuer enjoys a good credit rating by global rating agencies. The
following table shows the relative advantages of FC loans and global debt paper.
Mobilising FC funds
Syndicated loans Issue of Debt paper
Foreign currency loans are approved
by a bank or a group of banks,
onshore as well as offshore, after
credit appraisal
The debt paper is issued in global
markets i.e. outside India and is
subscribed by investors across the
markets (Qualified institutional
investors in most cases)
Bank loans are generally subject to
charge on specific assets in addition
to corporate/personal guarantees
The debt issue generally not backed
by specific security. The security is
often a negative charge on assets,
some times, guarantees by holding
company and/or a floating charge on
collaterals. The seniority of the debt
in case of bankruptcy is however pre-
established
Loan document contains several
covenants which, if breached, may
cause recall of the loan even before
the loan is due
The terms of issue are stated in the
prospectus the terms are finalized
by the issuer in consultation with
the arrangers taking into account the
requirements of targeted investor
community
Sanction of loans is subject to
individual/group exposure limits of
the bank, as also limits on country
exposure
There are no regulatory requirements
unless the debt paper is issued in
domestic markets (like in US or
Japan)
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Syndicated loans
An Indian company may approach its banker, or a bank acting as an
arranger for foreign currency loans of any size. The syndication i.e. participation
by a number of banks takes place only in case of larger loans. The lenders
generally reserve the right to transfer the loan (to sell the loan) to other banks
willing to acquire the risk with or without the consent of the borrower. The
transfer may take place at nominal value of the outstanding loan and the buying
bank may sometime also receive a part of the management fees collected
by the originating bank(s). The transfer of loan doesnt have any impact on
the conduct of the loan, or security offered for the loan and the rights and
obligations of the borrower remain unchanged.
The loan syndication takes place when the participating banks accept
credit risk of the borrower. Credit rating is generally done internally by the
banks or by the arranger who vets the loan proposal and conducts due
diligence. Participating banks are often constrained by their exposure limits to
the borrower group and to the borrowers country.
The borrowers submit periodical information apart from published
accounts to the lending banks who regularly monitor compliance with the loan
covenants. The advantage to the borrower is the ease of communicating with
the known lenders, planning the draw down as per requirements and possibility
of restructuring the loan in case of any cashflow issues. The management fees
charged by the bankers to the syndicated loan is likely to be lower than the
issue expenses in case of the global debt paper.
Syndicated loans Issue of Debt paper
Bank loans are transferable subject to
mutual consent but are not traded in
the market
The prepayment of a loan takes place
only if there is a put or call option
built into the terms of issue. The debt
may be restructured with change in
terms
Bank loans are also subject to
compliance with the regulatory
requirements of host country as well
as domestic regulators
The debt paper - floating rate notes
or fixed income bonds are actively
traded in the secondary market
provided the credit rating of the
issuer is acceptable. The debt paper is
constantly re-priced in a liquid market
Bank loans are stated at historical
value
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Issue of debt paper
The issuer company, say an Indian company, issues the debt paper
as a global bond to be subscribed by investors outside India. Generally the
subscriptions are by way of private placement with qualified institutional
investors. The global bonds may be issued with fixed or floating rate of interest,
in the latter case, linked to a well established benchmark (LIBOR) in any of the
major currencies.
Although the debt paper is generally referred to as global bond, there
are any number of debt instruments that may be issued in global markets.
Issue of USD debt in Global or US Domestic Markets
USD debt paper may be issued to non-US investors, or to US investors
outside US, or to investors in US domestic market. The USD bonds are issued
a) under regulation S (reg S issues) where the issue can be placed with qualified
investors outside US, not subject to SEC regulations or b) under Section 144A
to be placed with qualified institutions within the US after complying with SEC
regulations. Similarly JPY bonds can be issued as offshore bonds outside Japan,
or as Samurai bonds, open for subscription by investors in Japan.
Features of some of the types of bonds popular with global investors are
discussed below.
Coupon bearing bonds
Global bonds may be issued with zero coupon, redeemable at the end
of fixed period, where the interest amount is embedded into the principal,
initial subscription being a discounted amount. Bonds are also issued with a
coupon, fixed or floating. Floating rate of interest is linked to a benchmark
rate of interest (most commonly to LIBOR, or local inter bank market rate
like SIBOR). At times coupon may also be linked to an index (e.g. inflation
index).
However, irrespective of fixed or floating coupon, a USD bond is
generally quoted in the secondary market with reference to Treasury yields,
(e.g. T+ 50 bp or 60 bp) based on current market price of the bond.
Exchangeable Notes/bonds
The bonds have an option to be exchanged with the shares of a
company associated with the issuer (generally a subsidiary or a special purpose
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vehicle) after a predefined period. The objective of the issue is to fund the
associates business, when the associate is a start-up business or is implementing
a project, hence in initial stages, is not able to mobilize funds on its own. Once
the associate has a profitable business, the bond holder may prefer to exchange
the bond with the equity of the associate which may be considered to be
more valuable. Thus initial risk is absorbed by the parent company, without
a repayment obligation if the performance of the associate company is as per
expectations.
Medium Term Notes
Medium term notes are expected to have a tenor of 5 to 10 years
and are not underwritten but in usage MTN is used to refer to any debt
instrument with tenor over 1 year. Generally MTN, as distinct from bonds,
has come to be associated with intermittent or continuous drawings. If SBI
issues medium term notes of USD 1 bn for 3 years at 3M LIBOR + 150 bp,
the draw down is such that SBI may draw and recycle the debt for any tenor
within the 3-year period, subject to aggregate outstanding not being in excess
of USD 1 bn at any point of time. Thus SBI has access to need based funds at
pre-defined cost during the period of 3 years. In order to make sure that each
of the sub-issues are fully subscribed, SBI may also seek from the arranging
bank, a revolving underwriting facility, which of course, adds underwriting
commission to the interest cost.
Optionality
Global bonds may be issued with embedded call or put options. A call
option reduces the interest rate risk to the issuer, as he can call back the debt
if interest rates are falling. Put option is in favour of the investor, who can
sell back the bonds to the issuer, if interest rates are rising, or if he perceives
credit risk to be increasing. Put/call option structures not only cater to the risk
appetite of the issuers and investors, but they also modify the duration of the
bond, making it more attractive to certain type of investors.
Convertibility Option
Debt convertible into equity of the issuer becomes an attractive
proposition both for the issuers and the investors in a rising market. Foreign
Currency Convertible Bonds (FCCB) were popular with Indian corporates for
quite some time. Convertibility option allowed companies to issue the bonds
with nominal or nil rates of interest, ploughing back the interest as redemption
141
premium, in case the convertibility option is not exercised. In most cases
however, the strike price for convertion was at a high premium over current
market value of the shares, and as a result the bonds were never converted
into equity. The redemption premium, amounting to compounded interest,
poses an undue strain on the cashflows of the issuers, particularly if the notional
interest cost was not provided for annually.
Convertible bonds, if priced fairly and coupled with prudential accounting
(as under IFRS), is an ideal instrument for high-growth companies, providing
them valuable capital at very low cost.
FCCB can be traded in secondary market with or without convertibility
option.
Perpetual Bonds
A perpetual bond is a debt that runs perpetually, and is not repayable.
The bonds have no maturity date, though some-times, bonds with very long
maturity (50 or 100 years) are also called perpetual bonds. The coupon on
such bonds is generally higher than the current market yield, the excess yield
in a way amounting to amortize the principal repayment. Current value of the
principal may become nil after, say, 20 or 25 years thereafter the return on
bonds working as an annuity to the investors. The advantage to the issuer is
that the perpetual bond is counted as part of capital, and hypothetically, cost
of the funds, post-tax, work out to be lower than cost of equity.
Asset-based securities
As part of securitization, future receivables (from sale or lease of goods
and services) are converted into ABS bonds or pass-through certificates, paid
out from the periodical receipts. The assets are parked with a fire-proof
company (a SPV held by the originator) which is not affected by the financial
health of the originator. The underlying assets are clearly defined and the
collections directly accrue to the holders of the PTC. Often, the originator may
retain a stake in the PTCs issued by the SPV, as a credit support arrangement,
with a subordinated interest. Mortgage-based securities (MBS) also fall under
similar category.
The issuer is benefited by off-loading the credit risk, and improving the
capital strength in a leaner balance sheet; the investor is comfortable with
known credit risk (generally always having a credit rating), exclusive charge on
the underlying assets, and a relatively high return.
142
ABS may have a liquid secondary market, but such securities have come
into disrepute in the recent crisis in global financial markets (2008-09), on
account of incorrect credit rating practices, structural deficiencies and high
leverage with poor credit support.
Junk bonds
Generally global bond issues presuppose a good credit rating by
global credit rating agencies. Most often, a bond issue may require credit
rating of high-investment grade by two rating agencies, so as to make the
issue attractive to conservative investors like pension funds and insurance
companies. However there is also market for bonds with below-investment
grade rating, with relatively high default risk. Such bonds are generally traded
at discount, hence if the credit risk does not materialize, the return on
investment are quite high.
Many prominent companies, banks and financial institutions in India have
issued global bonds, mostly plain vanilla instruments (other than FCCB), such
as floating rate notes and medium term notes. Credit rating is mandatory for
issuers under RBI regulations, hence there are no junk bond issuers. Issuance
is mostly in USD, CHF and JPY currencies. Most USD bonds are Reg-S issues,
though SBI and ICICI are known to have issued recently USD bonds in US
domestic market under Section 144A. The FCCB are the only structured paper
issued by many Indian companies, particularly when credit rating was not a
prerequisite, and when there was no RBI guideline for setting the convertion
price (prior to 2008).
The process of issue of global debt paper starts from identifying
a merchant banker who would advise and execute the plan for issue of
appropriate debt instrument. The people associated with the debt issue in
various roles from inception to allotment include :
1. The Lead Manager* is the bank or investment institution who would
participate in preparation of the offer document and plan the details of the
issue such as the size, the timing, the target investors, road shows and the
pricing of the issue. He would also select in consultation with the issuer,
co-lead managers, who may specialize or have investor relations in specific
regions such as US, Europe, Middle East and Asia. The lead managers and
co-lead managers are selected not only on the strength of their ranking
in deal tables (track record) but also in order to achieve geographical
diversity of investors.
143
2. The Underwriters are the arrangers who would market the issue and
underwrite subscription of the issue at the final stages. While in general
the lead managers may underwrite the issue, other investment institutions
may also participate in the underwriting.
3. The Managers* are amongst the committed initial subscribers to the
issue and are promised allotment at a discount over the offer price. The
managers are expected to be the market makers offering two way quotes,
in order to develop a liquid secondary market for the debt.
4. Issuing and Paying Agents (IPA)* are generally banks where the
subscription to the issue takes place. The operative account with the IPA
is used for routing all payments and expenses connected with the issue.
5. The Custodian* is a domestic bank or financial institution who will hold
the securities, if any, charged under the debt, as a trustee on behalf of the
investors.
6. The Auditors the auditors are charged with due diligence, and
verification of accounts of the issuers and their report would form part
of the issue document. The Auditors would also help in the process for
obtaining credit rating, which should ideally precede the planning for the
issue.
7. The Solicitors* would take care of all documentation relating to
the issue including legal aspects of issue document, listing agreement,
agreement with depositories, etc. Often the solicitors would also be
conducting the due diligence with the aid of auditors.
(* also common to loan syndication)
From the issuers perspective, the process of issuing debt paper may progress
in the following stages:
Identify the funding requirement project expenses/rupee working
capital, etc.
Obtain credit rating by a global rating agency
Select Arrangers, Advisors and Issuing and Paying Agents
Choose currency and product structure: FRNs or MTNs or Structured
Bonds
144
sec 144a / reg s $-issue
euro bond / samurai JPY issue
put / call issue
Arrive at indicative pricing and all-in cost
Conduct due diligence / obtain legal opinion
Finalise Offer Memorandum
Select centres for Road Shows
Conclude allotment and placement of the issue
List in stock exchange (preferred: Luxemburg or Singapore)
Plan utilization of funds : yield enhancement
Hedge currency and interest rate risks
Check documentation Listing agreement, depository agreements and
ISDA Master Agreement
The all-in cost of the debt issue is very important factor as the
management fee to the arrangers, the underwriting fee, the fee for auditors
and solicitors, and the expenses for road shows may add to the cost of debt
significantly. Depending on the size of issue, all the incidental expenses are
negotiable and Lead Arrangers may sometimes agree to provide a capo for
such expenses.
Pending utilization, the proceeds of the debt issue are parked in off-shore
banks or with domestic banks the interim use of funds may some-times be
subject to restrictions by RBI. If the funds are parked off-shore banks may
suggest yield-enhancement structures. Care must be taken to avoid risks in such
structures, and if the returns are attractive, protection of principal and minimum
return on funds should be ensured.
Lastly, hedging of currency and interest rate risks is essential, as the
balance sheet risks are of long-term nature. As discussed under liability
Management in previous sections, a hedging strategy, complying with regulatory
requirements should be documented. The all-in cost for the issue must always
include the prospective hedging cost, in order to preserve the cost advantage
of FC borrowing over domestic debt.
mmm
145
Trade Finance
Cross-border trade, involving export and import of goods and services,
is the primary cause served by foreign exchange. The payments are settled
in a free currency acceptable to both the trading partners. Bilateral / regional
agreements may permit payments in currencies, which are not fully convertible
such as erstwhile Indo-Soviet Rupee trade and ACU settlement system - but
scope of such payments is highly limited. Today, USD, as Reserve Currency,
dominates global payment and settlement systems.
Evolution of world trade has been greatly helped by World Trade
Organization. WTO, born out of Uruguay Round of Trade Discussions (1986-
94), officially replaced General Agreement on Tariffs and Trade (GATT) - an
offshoot of UNO - in January 1995. WTO focuses on liberalization of global
trade, negotiates trade agreements binding upon participating countries, and
provides for a dispute resolution mechanism. Today there are 153 countries
participating in WTO.
While Uruguay Round resulted in major reductions in tariffs, the Doha
Round, launched in 2001 aimed at further liberalization of trade, reduction
in export subsidies, free access to agriculture and service sectors etc. The
discussions so far were largely successful in access to banking and service
sectors, protection of intellectual property rights and further reduction in tariffs,
as part of Doha Development Agenda. However, the latest round of discussions
held in December 11 in Geneva, witnessed continuing deep divisions between
developed and developing countries on sensitive issue pertaining to agriculture,
labour and environment.
WTO, despite partial success in Doha Round, greatly facilitated world
trade, its chief contribution being free access to non-agricultural markets,
significant reduction in tariffs and a platform for dispute resolution where
incidentally, China and India have been major complainants on violation of trade
agreements.
10
CHAPTER
146
Indias Foreign Trade
In the Indian context, the export-import trade is regulated by EXIM
Policy (2009-14). The Policy is issued for a 5-year period, with annual up dates,
in order to provide a stable environment for the foreign trade. While the exim
trade is largely liberalized, the Policy provides for a few items under banned list
and under canalized list. The Policy also provides for registration of exporters
and importers.
Indias foreign trade amounted to around 1.3% of global trade as at the
end of April 2010. This however is an improvement from the share of 0.92%
in 2003.
Indian exports for the period Apr-Sept 11, including software exports,
amounted to USD 181 mn (pr period 132.00), while imports amounted to USD
237 mn (pr period 178.00), showing an increase of 37% and 33% respectively,
over corresponding period previous year. The net flows show a current account
deficit of USD 33 bn, about 11% increase over previous period. The current
account deficit however, is compensated by surplus on capital account which
stood at USD 41 bn for the Apr-Sept 11 period (pr period 39.00). At the same
time, overall investment inflows declined to USD 14 bn for the same period,
from USD 31 bn in the previous period the decline is attributed to global
liquidity problems arising out of sovereign debt crisis in European Union.
Trade Finance
The foreign exchange and funding part of the trade is regulated by
Reserve Bank of India. RBIs Master Circulars on Export and Import of Goods
and Services, and other guidelines issued from time to time are binding on the
exporters and importers. There are also specialized institutions like Exim Bank
and ECGC to provide funding and non-funding assistance to exim traders.
Funding of exim trade may take place in two ways. Suppliers credit
is credit offered privately by the counter-party in case of imports, it is the
credit availed from the overseas supplier, and in case of exports, it is the
credit extended by the domestic exporter to the overseas importer. The credit
may often be clean, or supported by a letter of credit, bank guarantee or an
acceptance facility.
The other type of funding exim trade is by way of bank credit, extended
for the specific import / export transaction or for general working capital
147
requirement. Credit insurance or credit guarantee issued by ECGC (and other
insurance agencies, domestic as well as global) facilitates such bank credit.
A few of the most common credit facilities for export and import trade
are described below.
Letter of Credit
Letter of Credit (LC) is most commonly used instrument in foreign trade,
particularly in Asian countries.
LC is an assurance by a bank, to make payment against delivery of
specified documents, on behalf of its importer client, to the overseas exporter,
provided the documents comply with pre-set terms of the LC and are delivered
before expiry of the LC.
Very often, the exporter overseas has no personal knowledge of credit
status of the importer, and the LC issued by a reputed bank protects him from
default risk. The exporter can also avail working capital credit from his banker,
on the strength of the LC. Similar advantages accrue to the domestic exporter,
who receives the LC from overseas importer, covering his export proceeds.
The advantage to the importer is that he can specify in the LC,
documents fulfilling all quantitative and qualitative requirements, and draws
comfort from the fact that the payment under LC will be released only if he is
satisfied with the documents received under the LC.
Legal status of the LC is derived from the Uniform Customs Code and
Practice (UCP), issued by the International Chamber of Commerce (ICC) and is
accepted by all the member countries. The UCP is updated from time to time,
and currently UCP 600 issued in July 07 is applicable to international trade. The
LC on the face of it must mention that it is issued subject to UCP 600, stating
(in rare cases) if there are any exceptions.
The chief characteristic of LC is that it is independent of the physical
goods or services underlying the trade, and the obligation under LC is purely
subject to delivery of specified documents. The LC issuing bank therefore
checks the documents meticulously before making payments. Discrepancies,
if any, in the documents must either be corrected, or be accepted by the
importer, before releasing the payment. For this reason, the LCs are generally
described as documentary credits.
148
The documents required under the LC may be of various types, but
generally include
Financial documents a bill of exchange or promissory note, if credit
period is allowed after delivery of documents
Commercial documents invoice, packing list, quality specifications etc.
Shipping documents Bill of lading / Airways bill / multi-model transport
receipt etc.
Official documents Certificate of Origin, certificate of inspection of
quality, export license if any, etc.
Insurance insurance document covering specified risks
The LC also includes terms of sale (INCO terms like CIF, FOB please
see annexure) to indicate if the cost of freight and insurance is to be born by
the buyer or the seller. The various parties, apart from the opener (importer)
and the beneficiary (exporter), involved in the LC business are:
The issuing bank generally the importers bank, or the bank having
AD license to issue foreign letters of credit
The confirming bank if the issuing bank is not well known or is
considered to be weak, the LC may be confirmed by a correspondent bank, a
well-known global bank, or any other bank acceptable to the beneficiarys bank.
The confirming bank assumes full responsibility for payment under the LC on
behalf of the issuing bank.
The advising bank the LC is advised through the banker of the
beneficiary, or by any bank having a correspondent relationship with the
issuing bank, and has a presence in the beneficiarys country. The advising bank
authenticates the LC, before advising it to the beneficiary.
The negotiating bank the bank who checks the do0cuments and
advances the payment to the beneficiary by discounting the bill on the strength
of the LC.
The reimbursing bank the issuing bank settles payment under the LC
through its correspondent bank where it maintains an account in the specific
currency.
The UCP 600 defines the rights and obligations of all the participating
banks and institutions dealing with the LC.
149
There are different types of LC to suit the requirements of the
beneficiary. The LCs commonly used are:
LC (D/P) or (D/A) The LC amount is payable against delivery of
documents (at sight) under D/P terms. A credit period is allowed for
payment under D/A terms where the bank delivers documents against
acceptance of the bill of exchange by the importer.
Revocable and Irrevocable LCs Most of the LCs are irrevocable, that
is, the LC once issued cannot be cancelled. LC can also be revocable,
but the issuing bank will continue to be liable for bills negotiated by the
beneficiarys bank before the revocation notice is received.
Revolving LC A LC may cover a series of transactions, within the expiry
date, subject to a cap on the outstanding balance. Once a bill is settled,
the limit under the LC gets restored and becomes available for the next
transaction.
Transferable / Back-to-back LCs the beneficiary may transfer the LC or
arrange to open another LC by his bank, on the strength of the original
LC, in favour of a third party, if the LC terms so permit. The arrangement
is useful if the exporter is subcontracting his order, or is sourcing materials
from other suppliers.
Stand-by LC (SBLC) is a clean LC, as distinct from a documentary
credit, where the issuing bank undertakes unconditionally to honour
claims submitted under the LC, either at sight or after a usance period.
The SBLC often is a simple arrangement for lending funds against bank
guarantee.
While the LC is most commonly used in international trade, LC can also
be opened to facilitate domestic purchases hence a distinction is to be made
between foreign LCs and inland LCs.
The exporter as well as the importer have several avenues to raise
funds to meet their working capital requirements, the former for manufacture,
assembly and delivery of the goods (or services), and the latter for honouring
the payment under the import transaction.
It is pertinent to remember that in Indian context, RBI permits maximum
credit period f 1-year for import payments. An exception is made in case of
capital goods imports where the credit period can be extended up to 3 years
150
under ECB rules. Export realization must also take place within 1-year period,
but the banker can allow extension of the period subject to certain conditions.
Some of the common credit facilities are described below.
Export Credit
Export Packing Credit Banks make available packing credit in Rupees
or in foreign currency (limited to free currencies), to the exporter against
confirmed export orders. Normal credit period is 180 days. RBI has
prescribed preferential interest rates for export credits, and provides export
refinance to banks at repo rates to compensate for the lower interest.
Export Bill Discounting banks may provide advance against export bills,
once the goods are shipped. The post-shipment finance can take any of
the following forms:
Foreign Bill Purchase (FBP) bank may advance rupee funds against the
export bills, pending realization of the proceeds
Foreign Bill Discounting (FBD) bank may discount the bills at current
value in FC or rupee terms, pending collection
Foreign Bill negotiation (FBN) bank may pay full value of the export bills
(or discounted value in case of D/A bills) on the strength of the LC. Under
FBN, primary responsibility for payment rests with the LC opening banks.
Banks however retain recourse to the beneficiary to cover their counter-
party bank risk.
Export Trust Receipt an exporter assigns his export order to the bank,
and avails funding for execution of the order. The bank will have full claim
on the inventory and export proceeds.
Import Credit
Letter of Credit LC is generally extended as a non-fund facility, with
a cash margin or collateral security. LC (DP) is considered as a secured
facility as the bank holds documents of title to the goods (bill of lading
etc.) till payment is received. LC (DA) is considered as a clean facility as
the bank parts with the documents, against importers acceptance of the
bill of exchange. Some banks treat LC as a funding facility, as the issuing
bank is finally liable for payment under the LC.
Import Trust Receipt an importer may avail funding for specific
transaction, assigning full rights to the bank on materials purchased and
151
sale proceeds (i e inventory and receivables). The ITR is preferred by
traders where the value addition is not significant, or where the imported
goods are to be reexported. A warehouse receipt may also constitute
security for the bank credit, if the imported goods are held in a bonded
warehouse, pending sale or reexport.
Buyers Credit on due date of payment of LC, the buyer may arrange
with his bankers for additional credit period, without delaying payment to
the beneficiary of the LC. The importers bank may facilitate this either by
rolling over the LC on changed terms, or by issuing a letter of undertaking
(or a comfort letter) in favour of a foreign bank, who would pay off the
overseas exporter on the original due date, and collect payment with
interest from the issuing bank on the extended due date.
Stand-by LC in case the original import was not under LC, on the due
date the importer may request his banker to issue a SBLC for an extended
period, subject of course, to appropriate security. The foreign bank on
the strength of the SBLC would discount the overseas exporters bills and
collect payment on the due date of the SBLC the discount charges are
normally to the account of the opener.
General
Regular working Capital the exporters and importers can use the regular
working capital facilities, cash credit or overdraft or a working capital term
loan, to fund their exim transactions in normal course.
Structured Trade Credit refers to a package of credit facilities customized
to suit the requirements of a client, and may involve a combination of
credit facilities described above.
Project exports and imports may have different requirements on
account of long payment period and increased risks in project execution.
There are specialized institutions like EXIM bank, IDFC and IIFCL who cater
to such requirements. The norms for project credit are set by Memorandum
of Instructions on Project & Service Exports (PEM) of RBI. A working
group headed by EXIM Bank, that include representatives of RBI, government,
lending institutions, banks and ECGC, facilitates single window clearance for all
approvals required for large projects (>USD 100 mn).
ECGC plays a support role protecting the interests of exporters,
protecting the credit risks of various types, till the export proceeds are realized.
152
The risks cover non-acceptance of the shipment, credit default as also sovereign
risks, if there is a problem in externalization of the funds. Often the ECGC
cover is a necessary collateral for obtaining export credit from banks.
There are also other domestic and global insurers (such as credit shield
of New India assurance and credit insurance of Euler Hermes through Bajaj
Allianz) who protect credit risk of external trade, but such protection is largely
limited to credit default by the buyer, after acceptance of the shipment.
External Credit external finance is available for large project, apart
from conventional ECB facility, from multilateral institutions (like IMF and ADB)
and export promotion agencies of foreign governments (e g EXIM Banks of US,
Japan and Korea). In particular, infrastructure projects may access the institutional
finance at concessional rates of interest, and at times with multi-currency options.
In most cases institutional finance is also linked to specific imports (known as ECA
credit), which is an added advantage to the project managers.
Exchange Rate Risk Management
Export and import trade is often conducted with slender margins, as global
markets are highly competitive. It is hence of utmost importance to protect
the rupee value of costs and revenue, denominated in foreign exchange. An
appropriate hedging strategy is of utmost importance and the hedging cost, on
par with funding costs, should be considered while calculating operating margins.
A word of caution also for funding imports / exports of large projects
from external sources. Medium and long-term credit in foreign currency is
highly vulnerable to currency and interest rate risks, which add upon the
underlying project related risks. A hedging strategy should therefore involve a
careful selection of hedging instruments, with a view to minimize the hedging
costs, as also capture any favourable movement in market rates. The viability of
the project should be established only after setting a benchmark for currency
cost that takes into account the market risk.
Abbreviations used in Chapter 10:
ECGC Export Credit Guarantee Corporation of India Ltd.
IDFC Infrastructure Development Finance Corporation Ltd.
IIFCL India Infrastructure Finance Corporation Ltd.
IMF International Monetary Fund
ADB Asian Development Bank
153
Annexure1
INCO Terms Commercial payment terms used in
international trade, as approved by International
Chamber of Commerce (ICC)
(Extract from ICC Rules)
Main features of the Incoterms 2010 rules
Two new Incoterms rules DAT and DAP have replaced the Incoterms
2000 rules DAF, DES, DEQ and DDU
The number of Incoterms rules has been reduced from 13 to 11. This
has been achieved by substituting two new rules that may be used irrespective
of the agreed mode of transport DAT, Delivered at Terminal, and DAP,
Delivered at Place for the Incoterms 2000 rules DAF, DES, DEQ and DDU.
Under both new rules, delivery occurs at a named destination: in DAT,
at the buyers disposal unloaded from the arriving vehicle (as under the former
DEQ rule); in DAP, likewise at the buyers disposal, but ready for unloading (as
under the former DAF, DES and DDU rules).
The new rules make the Incoterms 2000 rules DES and DEQ
superfluous. The named terminal in DAT may well be in a port, and DAT can
therefore safely be used in cases where the Incoterms 2000 rule DEQ once
was. Likewise, the arriving vehicle under DAP may well be a ship and the
named place of destination may well be a port: consequently, DAP can safely
be used in cases where the Incoterms 2000 rule DES once was. These new
rules, like their predecessors, are delivered, with the seller bearing all the
costs (other than those related to import clearance, where applicable) and risks
involved in bringing the goods to the named place of destination.
Classification of the 11 Incoterms 2010 rules
The 11 Incoterms 2010 rules are presented in two distinct classes:
RULES FOR ANY MODE OR MODES OF TRANSPORT
EXW EX WORKS
FCA FREE CARRIER
CPT CARRIAGE PAID TO
154
CIP CARRIAGE AND INSURANCE PAID TO
DAT DELIVERED AT TERMINAL
DAP DELIVERED AT PLACE
DDP DELIVERED DUTY PAID
RULES FOR SEA AND INLAND WATERWAY TRANSPORT
FAS FREE ALONGSIDE SHIP
FOB FREE ON BOARD
CFR COST AND FREIGHT
CIF COST INSURANCE AND FREIGHT
ROLE OF FINANCIAL SERVICES IN INTERNATIONAL TRADE
Financial Services
Banking Services
Insurance Services (traditional)
Credit Insurance
Risk Management
Focus on
Managing Currency Risk in Export-Import Business
Impact of FX Risk
FX Risk: Adverse movement of exchange rates
Strain on operating profit margins
Business become less competitive
Cost escalation
Domestic Sales vs. Export sales
Sources of Risk
FX Risk: Adverse movement of exchange rates
155
Cost escalation lower margins erosion of competitive strength
Volatility of Exchange Rates
No parallel shift in costs
Economic Exposure
Managed vs. Market determined exchange rates
Treasury mismanagement
Absence of strategic approach
Structural issues
Weak knowledge base
Treasury Risk Management
Some common errors in
Identifying exposures
Selection of benchmark rate
Product pricing
Natural set-off
Cross-currency transactions
Liability Management
Use of derivatives
Market view vs. Rule based hedging
Some Tips on Risk Management
Recognise hedging cost for pricing the product
A rational approach to budgeting
Choose target rate from
Budget Rate
Forward Rate
Spot rate (Invoice rate / Customs rate)
Costing Rate
Risk Adjusted Exchange Rate (RAER)
156
Caution on MTM values
Select appropriate derivatives
Do not ignore documentation & accounting aspects
Most Useful Derivatives: Forwards and Options
Forwards & Futures
Fixed value at market determined rate
Flexibility pre-utilisation / rollover
Exchange risk is substituted by interest rate risk
Loss of opportunity
Forwards vs. Futures
Who can benefit
Common Derivatives
Options & Option Products what are permitted instruments?
Plain Vanilla options
Participating Forwards
Put spreads & Call Spreads
When to use zero cost options?
Prohibited instruments
Hedging Strategies
Use of PCFC
Natural Hedge
Reliance on market view
Stop-loss & Take profit limits
Projected business
Hedging period
Internal approvals
157
Risk Management
Policy Approach
Target Setting
Hedging Strategy
Covered and Open Positions
Risk Monitoring
Tracking the Targets
Risk Limits
Permitted Instruments
Hedge Performance
Managing Other Risks
Commodity Risk
Forwards & Options are either expensive or risky
Physical hedging:
Inventory Management
Natural Hedge
Price escalation Clauses
Credit Risk
ECGC vs Global credit insurers
Prudential Practices
Funding Risk
Structured credit
ECA / Multi-currency options
Liquidity Management
BEST PRACTICES
Have a risk management policy
Put in place processes to track target rates
Define permitted instruments for hedging
158
Check MTM value at every step
Comply with risk limits on open position and stop loss limits
Commit risk capital for trading positions
Check impact on accounts
Review & update policy every year
mmm
159
Foreign Exchange & Treasury Risk Management
Reference Books
1 Cash & Derivatives Markets in Foreign Exchange
A V Rajwade (2010)
McGraw-Hill Education (India) Pvt Ltd
2* Foreign Exchange - An Introduction to Core Concepts
Mark Mobius (2009)
John Wiley & Sons (Asia) P Ltd.
3 Handbook of Debt Securities and Interest Rate Derivatives
A V Rajwade (2007)
Tata McGraw-Hill Publishing Co. Ltd.
4* International Financial Management
P G Apte (2006)
Tata McGgraw-Hill Publishing Co. Ltd.
5* Foreign Exchange Simplified
B. Srinivasan (2005)
Tata McGraw-Hill Publishing Co. Ltd.
6* Foreign Exchange, International Finance Risk Management
A.V. Rajwade 2004
Academy of Business Studies
7 Financial Institutions Management A Risk Management Approach
Anthony Saunders & Marcia Million Cornett (2006)
McGraw-Hill (Education) Asia
8* Bank Financial Management
Indian Institute of Banking & Finance (2010)
Macmillan Publishers India Ltd.
160
9 Multinational Finance
Adrian Buckley (5th ed. - 2003)
Prentice Hall
10 An Introduction to International Money and Foreign Exchange
Markets
Charles Van Marrewijk
Centre For International Economic Studies (2004)
http://www.adelaide.edu.au/cies/papers/0407.pdf
12 Risk Management in Banking
Joel Bassis (2002)
John Wiley & Sons Ltd.
13 Options, Futures & Other Derivatives
John C. Hull (5th ed. 2003)
Pearson Education (Singapore) Pte Ltd.
14* An Introduction to Derivatives & Risk Management
Don M. Chance (2004)
South-Western, Thomson Learning inc.
15 Credit Derivative Handbook 2003
Merrill Lynch Global Securities Research & Economics Group
Global Fundamental Equity Research Department
16* An Introduction to Foreign Exchange & Money Markets (Reuters
Financial Training)
London, UK Reuters Limited, 1999
17* Introduction to Foreign Exchange and Financial Risk Management
Ramesh Laxman
Shroff Publishers & Distributors Ltd
* Recommended for first-stage learning

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