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P. Yesuthasen

ON JULY 7, the rupee-based currency option made its appearance on the set of hedging instruments available to Indian corporates. The Reserve Bank of India now allows banks to offer this product in culmination of a process initiated about a decade back, when it was considered too early to introduce currency options involving the rupee, and banks were allowed to offer cross currency options on a back-to-back basis.

The option was a little known instrument in the country those days. It was a time when it was difficult to find a dozen people who could discuss the nuances of options, and a time when a senior banker talked of writing a call and then hedging the position by writing a put.

Fortunately, public knowledge has grown significantly, especially with the introduction of options in the stock market, and many are now aware of the instrument though not always of all its nuances. This is as good a time as any to introduce rupee-based currency options in the market. Derivatives, which are very useful for mitigating risk, can, in the hands of the uninitiated, themselves become sources of risk The central bank is rightly cautious and choosy about who it will allow to write options, and has not given all banks the permission to take positions in the instrument.

A bank can run an options book, with approval, only if it has good internal control and risk monitoring and management systems, and it meets some other conditions relating to net worth (at least Rs 200 crore), CRAR (at least 9 per cent), non-performing assets and profitability. Other banks which meet only the CRAR requirement are allowed to write options only on a back-to-back basis. This will ensure that customers are not denied access to the product. To begin with, banks can offer only plain vanilla European options.

In keeping with the policy that only those with a transactional need will be allowed access to the forex market, only customers who have genuine foreign currency exposures can buy call or put options. Only one hedge transaction is allowed for a particular exposure for a given time.

So, if an import transaction is covered with a forward contract the company cannot buy a call option as long as the forward contract is in place. The rules relating to booking, rolling over and reversing forward contracts apply to options as well. The RBI has, in the circular, clarified issues relating to quoting of the price, delivery as well as the banks' own hedging processes.

Customers are not allowed to write options just yet, but they can buy "packaged products" involving cost reduction structures "provided the structure does not increase the underlying risk". The RBI frowns on structures that lead to customer receiving premium because, in that case, he becomes the net seller and thereby adds to his risk.

Banks are required by the RBI to obtain an undertaking from customers interested in using the product that they have clearly understood its nature and inherent risks. One is not sure how far some banks will go to educate customers, but when it comes to "packaged products" customers should take some care. Though it may not always be apparent in the product description, an option-based structure that leads to cost reduction does involve the writing of an option by the customer and, therefore, leads to his taking on the risk associated with the seller.

The element of premium that the customer should receive for the option he writes is set off against the price paid for the option he buys resulting in the cost reduction that some marketing people try to pass off as a gift from the bank. The much-vaunted "zero cost" products actually take away value from plain vanilla instruments while reducing the cost to "zero".

In the early days there is bound to be considerable uncertainties in pricing but the market for plain vanilla calls and puts will soon settle at levels where sellers and buyers are comfortable.

The important thing is not to get carried away by the menu; companies should look closely at what is on offer and buy hedging products that suit their needs and their pockets.

(The author, a former Deputy Controller, RBI, is a Chennai-based forex consultant.)

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