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Hedging of Foreign Exchange Risk

Reserve Bank of India (RBI) has issued directions on risk management and inter-bank dealings for hedging of foreign exchange risk.

What is currency risk?

Currency risk means the potential for loss on account of movement in –

  • Exchange rates of Indian Rupee (INR) against a foreign currency.
  • Exchange rates of one foreign currency against another.
  • Interest rate applicable to a foreign currency.

What is hedging?

Hedging means the activity of undertaking a foreign exchange derivative / foreign currency interest rate derivative transaction to offset the impact of an anticipated / contracted exposure.

What is anticipated and contracted exposure?

Anticipated exposure means currency risk arising on account of current / capital account transactions that are proposed to be entered into in future
Contracted exposure that have been entered into

What is foreign exchange derivative and foreign currency interest rate derivative?

Foreign exchange derivative contract means a financial contract which derives its value from the change in the exchange rate of two currencies at least one of which is not INR and which is for settlement at a future date, i.e. any date later than the spot settlement date, provided that contracts involving currencies of Nepal and Bhutan shall not qualify under this definition
Foreign currency interest rate derivative contract interest rate of a foreign currency

What is the classification of users for Over-the-Counter (OTC) foreign exchange transactions?

  • User shall mean any person, whether resident in / outside India, other than an Authorised Dealer.
  • Authorised Dealers shall classify users as retail or non-retail for the purpose of offering foreign exchange derivative contracts and foreign currency interest rate derivative contracts.
  • The following users shall be eligible to be classified as non-retail users –
    • All India Financial Institutions (AIFIs) and Non-Banking Finance Companies (NBFCs) (including Standalone Primary Dealers (SPDs) and Housing Finance Companies (HFCs)).
    • Insurance Companies regulated by the Insurance Regulatory and Development Authority of India (IRDAI).
    • Pension Funds regulated by the Pension Fund Regulatory and Development Authority (PFRDA).
    • Mutual Funds and Alternative Investment Funds regulated by the Securities and Exchange Board of India (SEBI).
    • Resident users with (a) minimum net worth of ₹500 crore; or (b) minimum turnover of ₹1000 crore, as per the latest audited financial statements.
    • Person resident outside India other than individuals.
  • Any user who is not eligible to be classified as a non-retail user shall be classified as a retail user.
  • Any user who is otherwise eligible to be classified as a non-retail user shall have the option to get classified as a retail user.
  • Any user who is otherwise eligible to be classified as a retail user shall have the option to get classified as a non-retail user subject to the condition that the user makes a request to an Authorised Dealer in this regard and the Authorised Dealer is satisfied that the user has the risk management capabilities suitable for classification as a non-retail user.

Which products can be offered for OTC foreign exchange transactions?

  • Authorised Dealers may offer foreign exchange cash / tom / spot contacts, involving INR or otherwise, to users (both retail and non-retail).
  • Non-deliverable foreign exchange derivative contract (NDDC) means an OTC foreign exchange derivative contract in which there is no delivery of the notional amount of the underlying currencies of the contract and which is cash-settled. Deliverable foreign exchange derivative contract means an OTC foreign exchange derivative contract other than an NDDC.
  • NDDCs involving INR can be offered by an Authorised Dealer Category-I bank, provided the Authorised Dealer Category-I bank (or its non-resident parent bank) has an operating International Financial Services Centre (IFSC) Banking Unit (IBU).
    • If offered to resident users – shall be cash-settled in INR. 
    • If offered to non-resident users – shall be cash-settled in INR or any foreign currency.
  • Foreign exchange derivative contracts not involving INR and foreign currency interest rate derivative contracts, offered for purposes other than hedging –
    • If offered to resident users – shall be cash-settled in INR.
    • If offered to non-resident users – shall be cash-settled in INR or any foreign currency.
  • The directions are not applicable to money changing transactions.

What are eligible purposes for OTC foreign exchange transactions?

Entity offering product Product offered User of product Purpose of product
Authorised Dealers Foreign exchange cash / tom / spot contracts, involving INR or otherwise Any users Permissible current or capital account transactions
Authorised Dealers Deliverable foreign exchange derivative contracts involving INR Any users Hedging
Authorised Dealer Category-I banks with an operating IFSC Banking Unit NDDCs involving INR Resident users Hedging
Non-resident users No restrictions on purpose
Authorised Dealers Deliverable and non-deliverable foreign exchange derivative contracts not involving INR Any users No restrictions on purpose
Authorised Dealers Foreign currency interest rate derivatives Any users No restrictions on purpose
Authorised Dealers Currency swaps Resident users other than individuals Converting INR liability into a foreign currency liability
Resident retail users Converting INR liability into a foreign currency liability subject to existence of a natural hedge

What are other directions on OTC foreign exchange transactions?

  • While offering a foreign exchange derivative contract involving INR to a user, other than NDDCs involving INR offered to non-resident users, it shall ensure that the notional amount and tenor of the derivative contract does not exceed the value and tenor of the exposure.
  • Users may take position up to USD 100 million equivalent of notional value, across all Authorised Dealers, for hedging contracted exposure without the requirement to establish the existence of underlying exposure.

Who can deal in exchange traded currency derivatives?

Recognised Stock Exchanges and Recognised Clearing Corporations shall deal in or otherwise undertake the business relating to foreign exchange derivatives only after obtaining an authorization from RBI.

Which products can be offered under exchange traded currency derivatives?

  • Recognized Stock Exchanges may offer foreign exchange future / call option (European) / put option (European), involving INR or otherwise, to persons resident in / outside India.
  • Permitted currency pairs are – USD-INR, EUR-INR, GBP-INR, JPY-INR, EUR-USD, GBP-USD and USD-JPY.
  • The underlying for the foreign exchange option shall be the spot rate of the corresponding currency pair.
  • The tenor of the contact shall be up to 12 months.

What are eligible purposes for exchange traded currency derivatives?

Entity offering product Product offered User of product Purpose of product
Recognized Stock Exchanges Foreign exchange derivative contracts involving INR Any users Hedging contracted exposure
Foreign exchange derivative contracts not involving INR No restrictions on purpose

What are other directions on exchange traded currency derivatives transactions?

  • The user is allowed to take positions (long or short), without having to establish existence of underlying exposure, up to a single limit of USD 100 million equivalent across all currency pairs involving INR, put together, and combined across all Recognized Stock Exchanges.
  • Users intending to take position beyond USD 100 million (or equivalent) in contracts involving INR, in all exchanges put together shall ensure that the notional amount and tenor of the derivative contract does not exceed the value and tenor of the exposure.
  • Exchange traded foreign exchange derivative contracts, involving INR or otherwise, shall be cash settled in INR. 

From when are the directions applicable?

The directions on risk management and inter-bank dealings for hedging of foreign exchange risk shall come into effect from April 05, 2024.

What are other important concepts / definitions form the directions?

  • Leveraged derivative means an OTC derivative whose potential pay-out during the tenure of the derivative can be more than the notional amount of the contract or whose pay-out calculation involves effective multiplication, by a factor of more than 1.0 of either the notional amount or the underlying rate / price / index.
  • Mid-market mark means the price of the derivative that is free from profit, credit reserve, hedging, funding, liquidity, or any other costs or adjustments.
  • Forward rate agreement means a cash-settled OTC foreign currency interest rate derivative contract between two counterparties, in which a buyer will pay or receive, on the settlement date, the difference between a pre-determined fixed rate (FRA rate) and a reference interest rate, applied on a notional principal amount, for a specified forward period.

Foreign exchange forward means an OTC foreign exchange derivative contract involving the exchange of two currencies on a specified date in the future (more than two business days later) at a rate agreed on the date of the contract -
Foreign exchange future means an exchange traded foreign exchange derivative contract but does not include foreign exchange forward


Currency swap means an OTC foreign exchange derivative contract which commits two counterparties to exchange streams of interest payments and / or principal amounts in different currencies on specified dates over the duration of the swap at a pre-agreed exchange rate
Foreign exchange swap involving the actual exchange of two currencies (principal amount only) on a specified date (the near leg) and a reverse exchange of the same two currencies at a future date (the far leg), at rates agreed at the time of the contract
Interest rate swap means an OTC foreign currency interest derivative contract in which two counterparties agree to exchange one stream of future interest payments for another, applied on a notional principal amount, over a specified period


Foreign exchange call option (European) means an OTC / exchange traded foreign exchange derivative contract that gives the buyer the right, but not the obligation to buy an agreed amount of a certain currency with / for another currency at a specified exchange rate on a specified date in the future
Foreign exchange put option (European) to sell


Interest rate call option (European) means an OTC foreign currency interest rate derivative contract that gives the buyer the right, but not the obligation to buy an interest rate instrument or receive an interest rate on a notional principal at a pre-determined price / rate on a specified date in the future
Interest rate put option (European) to sell


Foreign exchange call spread means an OTC foreign exchange derivative contract involving simultaneous purchase and sale of equal number of OTC foreign exchange call options (European) of same expiry and different strike price
Foreign exchange put spread put options (European)


Covered foreign exchange call option means a written OTC foreign exchange call option where the writer of the option has a long position in the asset underlying the option
Covered foreign exchange put option put option short position in the asset underlying the option


Interest rate cap means a series of interest rate call options (European) (called caplets) in which the buyer of the option receives a payment at the end of each period when the underlying interest rate is above a rate agreed in advance
Interest rate floor put options (European) below a rate agreed in advance


Interest rate collar means an OTC foreign currency interest derivative contract where a market participant simultaneously purchases an interest rate cap and sells an interest rate floor on the same interest rate for the same maturity and notional principal amount
Reverse interest rate collar simultaneously purchases an interest rate floor and sells an interest rate cap

References

Reserve Bank of India. (2024, January 05). 'Risk Management and Inter-Bank Dealings - Hedging of foreign exchange risk'. Retrieved from https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0


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