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Many of the biggest names in Corporate India are telling the Reserve Bank of India (RBI) not to clamp down on currency derivatives — financial products that have baffled firms that never understood the risks and sparked court feuds with banks which sold them.
In the derivatives market, where companies with large foreign exchange exposures used the tools to cover their currency risks, the favourite was the zero-cost structure — an inexpensive, attractive, but often complex derivative that sold like hot cakes. RBI — which has proposed a ban on the product — thinks that zero-cost structures, with their leveraged nature have been the root cause of the problem plaguing the market.

But some of the biggest users of currency derivatives, like Infosys, Wipro and Essar, have told RBI that a blanket ban on zero-cost derivatives would take away the flexibility in managing the risks arising out of fluctuations in exchange rates.

A company entering into a zero-cost derivative contract with a bank simultaneously buys an option as well as sells another option to the bank. The deal happens in a way where the premium earned from selling an option is used to pay for buying the other option, making it zero cost for the company. However, many small firms with less sophisticated treasury operations lost out when the contracts had a high dose of leverage.

For instance, an exporter may have sold two or three or even five options to buy one put option. In trade parlance, these are called 1:2, 1:3 or 1:5 options. Here, the company could be badly hit, if exchanges rates move against it.

Indeed, more and more companies feel that RBI should fix a cutoff turnover or forex exposure so that firms above this are allowed to go for such contracts. Speaking to ET, S Mahalingam, CFO of TCS, India’s largest software vendor, said: “A distinction has to be made — is it a large company, a sophisticated user, someone who understands what it is going in for. The regulator can make sure the companies that opt for these instruments know what they are getting into. Of course, whoever opts for it is signing a contract, so they can’t turn around and say that they didn’t know what they were getting into. Some of the exotic contract that companies entered into 2-3 years ago were not only structured products, but also swaps.”


Take an exporter who expects to receive a payment of $10 million from its overseas buyer six months later. It can go for a plain vanilla forward contract with a bank which gives the exporter the choice to sell the dollar — it would receive — at 45 a dollar when the present market rate could be, say 43.50. But if the exporter does a zero-cost deal, the bank may offer a rate as high as 48, which allows him to earn Rs 3 more on every dollar he would earn.

Under a typical zero-cost deal, the exporter buys one put option, which gives it the ‘right’ to sell dollar at 48 to the bank; at the same time, it sells one call option — here, the exporter is ‘obliged’ to sell the dollar at 48 to the bank. Suppose, six months later, when the exporter receives the payment, the dollar is traded at 46. At this point, the exporter exercises the put option to sell dollar at 48, thus earning Rs 2 (per every dollar) more than the market rate.

What if the dollar touches 50 in the open market? Here, the market rate is more attractive than the pre-agreed rate the exporter has entered with the bank. But the exporter has no choice. The bank to whom it’s obliged to pay — as per the call option — will not miss the opportunity. It will make the exporter sell the dollar at 48 — a transaction where the exporter gets Rs 2 less than the open market rate for every dollar earned.

“If you want to protect a certain rate, I would simply take a forward cover. The reason why you take these structured products is because you are dealing with options, and you want to be protected against a range. Zero-cost derivatives are really a structure associated with options, and there is a benefit of using it,” said Mr Mahalingam. Rajendra Hinduja, MD of Gokaldas — one of India’s largest garment exporters — agreed that a blanket ban could backfire on exporters.

If the firm is leveraged; it has entered into a 1:3 contract. In other words, it has sold 3 options to buy one option. Here, the loss to the firm would be Rs 6 and not Rs 2 when the dollar is at Rs 50.

But instead of focusing on banning such instruments, said Mr Balakrishnan, regulators should focus on whether the corporate has adequate mechanism and structure to manage the risks at the board level, whether the corporates have made adequate disclosures to their investors and whether they follow appropriate accounting principles. Indeed, corporates have been told to make mark-to-market provisions if a derivative is ‘out of money’ against the prevailing market rate. Banks are also collecting margins and will have to organise extra capital if the client is facing a loss. When a client buying a derivative fails to honour the commitment, it’s like an unsecured loan — like credit card dues — that has turned sticky.

According to a banker, if RBI decides to ban zero-cost products, companies will structure the product in a way where option buying and selling happen through two separate transactions. “RBI’s draft proposal allows corporates to sell options — something that will happen for the first time. So, a corporate will sell an option and then, enter into a different agreement with the bank to buy an option. The two taken together is nothing but a zero-cost deal, though on paper these are two transactions. But this can happen if corporates have sufficient underlying since two underliers — like an export order or a loan document — have to be provided for the two transactions. In a zero-cost deal, a single underlying would have been adequate… But this is hardly a problem for large corporates which have enough underlying and big treasuries.”

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June 2024