In India, the forward markets facilitate the hedging of transactional and contractual exposures. Transactional exposures are allowed to be hedged up to the amount of the underlying exposure after providing documentary evidence of the transaction.
Contractual exposures are permitted to be hedged up to the extent of the previous year’s turnover or the average of the previous three years’ turnover, whichever is higher. Documents have to be provided at the time of the maturity of the contract. Since competitive exposure is based on the changes in technology, product mix, sources of inputs, marketing approach, shifting of production base etc, the measurement of competitive exposure is complex and can be inaccurate. It is for this reason that players are not allowed to hedge their competitive exposures in the forward market.
The foreign exchange market in India has grown and matured significantly in the last decade. This can be attributed to the more liberalized and globalized environment within which market participants’ function. As there has been increasing volatility in exchange rates and interest rates, there has been a greater need to hedge foreign exchange risk exposures.
The main players in the forward markets in India are the Authorized Dealers ( ADs).
These ADs are allowed to deal forward in any permitted currency.
The following entities can transact with the ADs in the forward market:
- The Reserve Bank of India can enter into swap transactions with the Ds, that is, it can buy or sell dollars spot and sells or buys dollars forward for maturities available in the market.
- A resident, that is, an importer or exporter can enter into forward contracts with ADs to hedge against exchange risks. These importers and exporters are bound by an eligible limit on the forward contracts. The eligible limit is defined as the average of the import or export turnover of the last three years or the previous year’s turnover, whichever is higher. The importer or exporter cannot exceed 100% of the eligible limit and if it does then any amount in excess of 25% of the eligible limit can be only on a deliverable basis.
- Foreign Institutional Investors (FIIs) are also eligible for forward contracts with ADs up to the full extent of their investments in debt and equity
- Foreign Direct Investors ( FDI) are also eligible to enter into forward contract with ADs for a period not exceeding six months. Besides, they are allowed to hedge their risk only after they have completed all formalities and obtained necessary approvals.
- Non Resident Indians (NRIs) can hedge the risks arising out of their dividend receipts, balances held in their FCNR accounts ( Foreign Currency Non Resident Accounts) or NRE accounts (Non Resident External Accounts) and their investments in portfolio investments schemes.
- Residents with overseas direct investment in equities and loans may also hedge against foreign exchange risks arising from such investments.
- All forward contracts booked by residents in respect of their foreign currency exposures falling due within one year are permitted to be cancelled and rebooked freely, subject to submission of details of import and non trade payment exposures by the constituents to their ADs on an annual basis. In the case of export contracts with a tenor greater than one year are permitted to be freely cancelled and rebooked.
- In the current scheme of things, hedging of foreign currency exposure is not permitted in the Indian forward market. This currency exposure arises when a customer who has a rupee exposure converts it into a foreign currency exposure through a rupee-foreign currency swap. In such a swap, the customer faces two types of risk, one is the currency risk , that is the fear of the depreciation of the rupee vs the foreign currency and the other is the interest rate risk, the fear that the foreign currency denominated LIBOR (London Inter-bank Offer Rate) will rise.
- It would be tempting to equate a derived exposure in foreign currency to borrowing in foreign currency but the two are quite different. While borrowings in foreign currency have well laid down rules for accessing, it would be difficult to have such tangible rules in the case of derived foreign currency exposures. Such exposures would therefore be tantamount to giving freedom to freely access to foreign exchange market without an underlying forex exposure.
- In the case of borrowings in foreign currency too, there are controls. Banks are not allowed to borrow from the foreign market beyond a certain limit or perform Buy/ Sell swaps beyond a certain limit. This is because it would have important capital account implications. In the case of continued rupee appreciation, corporates would borrow foreign currency and sell it to generate rupee for working capital requirements. The excess supply of dollars thus generated will have to be mopped up by the RBI. If banks were allowed to borrow excessively in foreign currency then, the banks would go in for more and more Buy/ Sell swaps to generate foreign currency for lending and meet foreign currency payments. The premia on the foreign currency will then move into discount and covered interest parity will hold.