Comprehensive Guidelines on Foreign Exchange Derivatives

To Avail Buyer’s / Supplier’s Credit: E: sanjaymandavia@gmail.com, M: +919825560186

RBI via circular dated 28/12/2010 revised the extant guidelines on OTC (Over the Counter) Foreign  Exchange Derivatives and which became effective from 1st February 2011. Below is the extract of the guidelines related to importers and exporters.

Facilities to Persons resident in India are detailed in following three sub heads

1) Contracted Exposures

AD Category I banks have to evidence the underlying documents so that the existence of underlying foreign currency exposure can be clearly established. AD Category I banks, through verification of documentary evidence, should be satisfied about the genuineness of the underlying exposure, irrespective of the transaction being a current or a capital account. Full particulars of the contracts should be marked on the original documents under proper authentication and retained for verification. However, in cases where the submission of original documents is not possible, a copy of the original documents, duly certified by an authorized official of the user, may be obtained. In either of the cases, before offering the contract, the AD Category I banks should obtain an undertaking from
the customer and also quarterly certificates from the statutory auditor (for details refer section B para II (b) for General Instructions). While details of the underlying have to be recorded at the time of booking the contract, in the view of logistic issues, a maximum period of 15 days may be allowed for production of the documents. If the documents are not submitted by the customer within 15 days, the contract may be cancelled, and the exchange gain, if any, should not be passed on to the customer. In the event of non-submission of the documents by the customer within 15 days on more than three occasions in a financial year, booking of permissible derivative contracts in future may be allowed only against production of the underlying documents, at the time of booking the contract.

The products available under this facility are as follows:

i) Forward Foreign Exchange Contracts Participants

Market-makers – AD Category I banks
Users – Persons resident in India

Purpose
a) To hedge exchange rate risk in respect of transactions for which sale and /or purchase of foreign exchange is permitted under the FEMA 1999, or in terms of the rules/ regulations/directions/orders made or issued there under.
b) To hedge exchange rate risk in respect of the market value of overseas direct investments (in equity and loan).

i) Contracts covering overseas direct investment (ODI) can be cancelled or rolled over on due dates. However, AD Category I banks may permit rebooking only to the extent of 50 per cent of the cancelled contracts.
ii) If a hedge becomes naked in part or full owing to contraction ( due to price movement/impairment) of the market value of the ODI, the hedge may be allowed to continue until maturity, if the customer so desires. Rollovers on due date shall be permitted up to the extent of the market value as on that date.

c) To hedge exchange rate risk of transactions denominated in foreign currency but settled in INR, including hedging the economic (currency indexed) exposure of importers in respect of customs duty payable on imports.

i) Forward foreign exchange contracts covering such transactions will be settled in cash on maturity.
ii) These contracts once cancelled, are not eligible to be rebooked.
iii) In the event of any change in the rate(s) of customs duties, due to Government notifications subsequent to the date of the forward contracts, importers may be allowed to cancel and/or rebook the contracts before maturity.

Operational Guidelines, Terms and Conditions

General principles to be observed for forward foreign exchange contracts.

a) The maturity of the hedge should not exceed the maturity of the underlying transaction. The currency of hedge and tenor, subject to the above restrictions, are left to the customer. Where the currency of hedge is differentfrom the currency of the underlying exposure, the risk management policy of the corporate, approved by the Board of the Directors, should permit such type of hedging.
b) Where the exact amount of the underlying transaction is not ascertainable, the contract may be booked on the basis of reasonable estimates. However, there should be periodical review of the estimates.
c) Foreign currency loans/bonds will be eligible for hedge only after final approval is accorded by the Reserve Bank, where such approval is necessary or Loan Registration Number is allotted by the Reserve Bank.
d) Global Depository Receipts (GDRs)/American Depository Receipts (ADRs) will be eligible for hedge only after the issue price has been finalized.
e) Balances in the Exchange Earner’s Foreign Currency (EEFC) accounts sold forward by the account holders shall remain earmarked for delivery and such contracts shall not be cancelled. They are, however, eligible for rollover, on maturity.
f) All non-INR forward contracts can be rebooked on cancellation subject to condition (h) below. Forward contracts, involving the Rupee as one of the currencies, booked by residents to hedge current account transactions, regardless of the tenor, and to hedge capital account transactions, falling due within one year, may be allowed to be cancelled and rebooked subject to condition (h) below. This relaxation of cancellation and rebooking will not be available to forward contracts booked on past performance basis without documents as also forward contracts booked to hedge transactions denominated (or indexed) in foreign currency but settled in INR.
g) The facility of cancellation and rebooking is not permitted for forward contracts, involving Rupee as one of the currencies, booked by residents to hedge capital account transactions for tenor greater than one year. These forward contract(s) if cancelled with one AD Category I bank can be rebooked with another AD Category I bank, subject to the following conditions:

(i) the switch is warranted by competitive rates on offer, termination of banking relationship with the AD Category I bank with whom the contract was originally booked;
(ii) the cancellation and rebooking are done simultaneously on the maturity date of the contract; and
(iii) the responsibility of ensuring that the original contract has been cancelled rests with the AD Category I bank who undertakes rebooking of the contract.

h) The facility of rebooking should not be permitted unless the corporate has submitted the exposure information as prescribed in Appendix B.
i) Substitution of contracts for hedging trade transactions may be permitted by an AD Category I bank on being satisfied with the circumstances under which such substitution has become necessary. The AD Category I bank may also verify the amount and tenor of the underlying substituted.

ii) Cross Currency Options (not involving Rupee) Participants

Market-makers – AD Category I banks as approved for this purpose by the RBI
Users – Persons resident in India

Purpose

a) To hedge exchange rate risk arising out of trade transactions.
b) To hedge the contingent foreign exchange exposure arising out of submission of a tender bid in foreign exchange.

Operational Guidelines, Terms and Conditions

a) AD Category I banks can only offer plain vanilla European options (A European option may be exercised only at the expiry date of the option, i.e. at a single pre-defined point in time)
b) Customers can buy call or put options.
c) These transactions may be freely booked and/ or cancelled subject to verification of the underlying.
d) All guidelines applicable for cross currency forward contracts are applicable to cross currency option contracts also.
e) Cross currency options should be written by AD Category I banks on a fully covered back-to-back basis. The cover transaction may be undertaken with a bank outside India, an Off-shore Banking Unit situated in a Special Economic Zone or an internationally recognized option exchange or another AD Category I bank in India. AD Category I banks desirous of writing options, should obtain a one-time approval from the Chief General Manager, Reserve Bank of India, Foreign Exchange Department, Forex Markets Division, Central Office, Amar Building 5th Floor, Mumbai, 400001, before undertaking the business.

iii) Foreign Currency – INR Options

Participants

Market-makers – AD Category I banks, as approved for this purpose by the RBI.
Users – Persons resident in India

Purpose

a) To hedge foreign currency exposures in accordance with Schedule I of Notification No. FEMA 25/2000-RB dated May 3, 2000, as amended from time to time.
b) To hedge the contingent foreign exchange exposure arising out of submission
of a tender bid in foreign exchange.

Operational Guidelines, Terms and Conditions

a) AD Category I banks having a minimum CRAR of 9 per cent, can offer foreign currency– INR options on a back-to-back basis.
b) For the present, AD category I banks can offer only plain vanilla European options.
c) Customers can buy call or put options.
d) All guidelines applicable for foreign currency-INR foreign exchange forward contracts are applicable to foreign currency-INR option contracts also.
e) AD Category I banks having adequate internal control, risk monitoring/management systems, mark to market mechanism, etc. are permitted to run a foreign currency– INR options book on prior approval from the Reserve Bank, subject to conditions. AD Category I banks desirous of running a foreign currency-INR options book and fulfilling minimum eligibility criteria listed below, may apply to the Reserve Bank with copies of approval from the competent authority (Board/ Risk Committee/ ALCO), detailed memorandum in this regard, specific approval of the Board for the type of option writing and permissible limits. The memorandum put up to the Board should clearly mention the downside risks, among other matters.

Minimum Eligibility Criteria:
i. Net worth not less than Rs 300 crore
ii. CRAR of 10 per cent
iii. Net NPAs not exceeding 3 per cent of the net advances
iv. Continuous profitability for at least three years

The Reserve Bank will consider the application and accord a one-time approval at its discretion. AD Category I banks are expected to manage the  option portfolio within the Reserve Bank approved risk management limits.

f) AD banks may quote the option premium in Rupees or as a percentage of the Rupee/foreign currency notional.
g) Option contracts may be settled on maturity either by delivery on spot basis or by net cash settlement in Rupees on spot basis as specified in the contract. In case of unwinding of a transaction prior to the maturity, the contract may be cash settled based on market value of an identical off-setting option.
h) Market makers are allowed to hedge the ‘Delta’ of their option portfolio by accessing the spot and forward markets. Other ‘Greeks’ may be hedged by entering into option transactions in the inter-bank market.
i) The ‘Delta’ of the option contract would form part of the overnight open position.
j) The ‘Delta’ equivalent as at the end of each maturity shall be taken into account for the purpose of AGL. The residual maturity (life) of each outstanding option contract can be taken as the basis for the purpose of grouping under various maturity buckets
k) AD banks running an option book are permitted to initiate plain vanilla cross currency option positions to cover risks arising out of market making in foreign currency-INR options.
l) Banks should put in place necessary systems for marking to market the portfolio on a daily basis. FEDAI will publish daily a matrix of polled implied volatility estimates, which market participants can use for marking to market their portfolio.
m) The accounting framework for option contracts will be as per FEDAI circular No.SPL-24/FC-Rupee Options/2003 dated May 29, 2003.

iv) Foreign Currency-INR Swaps

Participants

Market-makers – AD Category I banks in India.

Users

i. Residents having a foreign currency liability and undertaking a foreign currency-INR swap to move from a foreign currency liability to a Rupee liability.
ii. Incorporated resident entities having a rupee liability and undertaking a INR –foreign currency swap to move from rupee liability to a foreign currency liability, subject to certain minimum prudential requirements, such as risk management systems and natural hedges or economic exposures. In the absence of natural hedges or economic exposures, the INR-foreign currency swap (to move from rupee liability to a foreign currency liability) may be restricted to listed companies or unlisted companies with a minimum net worth of Rs 200 crore. Further, the AD Category I bank is required to examine the suitability and appropriateness of the swap and be satisfied about the financial soundness of the corporate.

Purpose

To hedge exchange rate and/or interest rate risk exposure for those having long-term foreign currency borrowing or to transform long-term INR borrowing into foreign currency liability.

Operational Guidelines, Terms and Conditions

a) No swap transactions involving upfront payment of Rupees or its equivalent in any form shall be undertaken.
b) The term “long-term exposure” means exposures with residual maturity of one year or more.
c) Swap transactions may be undertaken by AD Category I banks as intermediaries by matching the requirements of corporate counterparties. While no limits are placed on the AD Category I banks for undertaking swaps to facilitate customers to hedge their foreign exchange exposures, a limit of USD 100 million is placed for net supply of foreign exchange in the market on account of swaps which facilitate customers to assume foreign currency liability. Positions arising out of cancellation of foreign currency-INR swaps by customers need not be reckoned within this cap.
d) With reference to the specified limits for swap transactions facilitating customers to assume a foreign currency liability, the limit will be reinstated on account of cancellation/ maturity of the swap and on amortization, up to the amounts amortized.
e) The swap transactions, once cancelled, shall not be rebooked or re-entered, by whichever mechanism or by whatever name called.
f) AD Category I banks should not offer leveraged swap structures. Typically, in leveraged swap structures, a multiplicative factor other than unity is attached to the benchmark rate(s), which alters the payables or receivables vis-à-vis the situation in the absence of such a factor.
g) The notional principal amount of the swap should not exceed the outstanding amount of the underlying loan.
h) The maturity of the swap should not exceed the remaining maturity of the underlying loan.

v) Cost Reduction Structures i.e. cross currency option cost reduction structures
and foreign currency –INR option cost reduction structures.

Participants

Market-makers – AD Category I banks

Users – Listed companies or unlisted companies with a minimum net worth of
Rs. 100 crore ( subsidiaries or affiliates of listed companies which follow AS 30/32, having common treasuries and consolidate the accounts with parent companies are exempted from the minimum net worth criteria), which are complying with the following:
• Adoption of Accounting Standards 30 and 32. Companies which are not complying fully with AS 30 and 32 should follow the accounting treatment and disclosure  standards on derivative contracts, as envisaged under AS 30/32.
• Having a risk management policy and a specific clause in the policy that allows using the type/s of cost reduction structures.

Purpose
To hedge exchange rate risk arising out of trade transactions and External Commercial Borrowings (ECBs).

Operational Guidelines, Terms and Conditions
a) Writing of options by the users, on a standalone basis, is not permitted.
b) Users can enter into option strategies of simultaneous buy and sell of plain vanilla European options, provided there is no net receipt of premium.
c) Leveraged structures, digital options, barrier options, range accruals and any other exotic products are not permitted.
d) The portion of the structure with the largest notional, computed over the tenor of the structure, should be reckoned for the purpose of underlying.
e) The delta of the options should be explicitly indicated in the term sheet.
f) AD Category I banks may, stipulate additional safeguards, such as, continuous profitability, higher net worth, turnover, etc depending on the scale of forex operations and risk profile of the users.
g) The maturity of the hedge should not exceed the maturity of the underlying transaction and subject to the same the users may choose the tenor of the hedge. In case of trade transactions being the underlying, the tenor of the structure shall not exceed two years.
h) The MTM position should be intimated to the users on a periodical basis.

vi) Hedging of Borrowings in foreign exchange, which are in accordance with the provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000.

Products – Interest rate swap, Cross currency swap, Coupon swap, Cross currency option, Interest rate cap or collar (purchases), Forward rate agreement(FRA)

Participants

Market-makers
a) AD Category I banks in India
b) Branch outside India of an Indian bank authorized to deal in foreign exchange in India
c) Offshore banking unit in a SEZ in India.

Users
Persons resident in India who have borrowed foreign exchange in accordance with the provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000

Purpose
For hedging interest rate risk and currency risk on loan exposure and unwinding  from such hedges Operational Guidelines, Terms and Conditions
a) The products, as detailed above should not involve the rupee under any  circumstances.
b) Final approval has been accorded or Loan Registration Number allotted by the Reserve Bank for borrowing in foreign currency.
c) The notional principal amount of the product should not exceed the outstanding amount of the foreign currency loan.
d) The maturity of the product should not exceed the unexpired maturity of the underlying loan.
e) The contracts may be cancelled and rebooked freely.

2) Probable exposures based on past performance

Participants
Market-makers – AD Category I banks in India.
Users – Importers and exporters of goods and services

Purpose
To hedge currency risk on the basis of a declaration of an exposure and based on past performance up to the average of the previous three financial years’ (April to March) actual import/export turnover or the previous year’s actual import/export turnover, whichever is higher. Probable exposure based on past performance can be hedged only in respect of trades in merchandise goods as well as services.

Products
Forward foreign exchange contracts, cross currency options (not involving the rupee), foreign currency-INR options and cost reduction structures [as mentioned in section B para I 1(v)].

Operational Guidelines, Terms and Conditions
a) Corporates having a minimum net worth of Rs 200 crores and an annual export and import turnover exceeding Rs 1000 crores and satisfying all other conditions as  stipulated in section B para I 1(v) may be allowed to use cost reduction structures.
b) The contracts booked during the current financial year (April-March) and the outstanding contracts at any point of time should not exceed the eligible limit i.e. the average of the previous three financial years’ actual import/export turnover or the previous year’s actual import/export turnover, whichever is higher.
c) Contracts booked in excess of 75 per cent of the eligible limit will be on deliverable basis and cannot be cancelled.
d) These limits shall be computed separately for import/export transactions.
e) Higher limits will be permitted on a case-by-case basis on application to the Foreign Exchange Department, Central Office, Reserve Bank of India. The additional limits, if sanctioned, shall be on a deliverable basis.
f) Any contract booked without producing documentary evidence will be marked off against this limit. These contracts once cancelled, are not eligible to be rebooked.  Rollovers are also not permitted.
g) AD banks should permit their clients to use the past performance facility only after satisfying themselves that the following conditions are complied with:

i. An undertaking may be taken from the customer that supporting documentary evidence will be produced before the maturity of all the contracts booked.
ii. Importers and exporters should furnish a quarterly declaration to the AD Category I banks, duly certified by the Statutory Auditor, regarding amounts booked with other AD Category I banks under this facility, as per Appendix M.
iii. For an exporter customer to be eligible for this facility, the aggregate of  overdue bills shall not exceed 10 per cent of the turnover.
iv. Aggregate outstanding contracts in excess of 50 per cent of the eligible limit may be permitted by the AD Category I bank on being satisfied about the genuine requirements of their customers after examination of the following documents:

• A certificate from the Statutory Auditor of the customer that all guidelines have been adhered to while utilizing this facility.
• A certificate of import/export turnover of the customer during the past three years duly certified by their Statutory Auditor in the format given in Appendix K.

h) The past performance limits once utilised are not to be reinstated either on cancellation or on maturity of the contracts.
i) AD Category I banks must arrive at the past performance limits at the beginning of every financial year. The drawing up of the audited figures (previous year) may require some time at the commencement of the financial year. However, if the statements are not submitted within three months from the last date of the financial year, the facility should not be provided until submission of the audited figures.
j) AD Category I banks must institute appropriate systems for validating the past performance limits at pre-deal stage. In addition to the customer declarations, AD Category I banks should also assess the past transactions with the customers, turnover, etc.
k) AD Category I banks are required to submit a monthly report (as on the last Friday of every month) on the limits granted and utilised by their constituents under this facility as prescribed in Appendix J.

3) Special Dispensation

i) Small and Medium Enterprises (SMEs)

Participants
Market-makers – AD Category I.
Users – Small and Medium Enterprises (SMEs) 3

Purpose
To hedge direct and / or indirect exposures of SMEs to foreign exchange risk

Product
Forward foreign exchange contracts

Operational Guidelines: Small and Medium Enterprises (SMEs) having direct and /or  indirect exposures to foreign exchange risk are permitted to book / cancel / rebook/ roll over forward contracts without production of underlying documents to manage their exposures effectively, subject to the following conditions:

a) Such contracts may be booked through AD Category I banks with whom the SMEs have credit facilities and the total forward contracts booked should be in alignment with the credit facilities availed by them for their foreign exchange requirements or  their working capital requirements or capital expenditure.
b) AD Category I bank should carry out due diligence regarding “user  appropriateness” and “suitability” of the forward contracts to the SME customers as  per Para 8.3 of ‘Comprehensive Guidelines on Derivatives’ issued vide   DBOD.No.BP.BC. 86/21.04.157/2006-07 dated April 20, 2007.
c) The SMEs availing this facility should furnish a declaration to the AD Category I bank regarding the amounts of forward contracts already booked, if any, with other AD Category I banks under this facility.

ii) Resident Individuals

Participants
Market-makers – AD Category I banks
Users: Resident Individuals

Purpose
To hedge their foreign exchange exposures arising out of actual or anticipated remittances, both inward and outward, can book forward contracts, without production of underlying documents, up to a limit of USD 100,000, based on self declaration.

Product
Forward foreign exchange contracts

Operational Guidelines, Terms and Conditions

a) The contracts booked under this facility would normally be on a deliverable basis. However, in case of mismatches in cash flows or other exigencies, the contracts booked under this facility may be allowed to be cancelled and re- booked. The notional value of the outstanding contracts should not exceedUSD 100,000 at any time.
b) The contracts may be permitted to be booked up to tenors of one year only.
c) Such contracts may be booked through AD Category I banks with whom the resident individual has banking relationship, on the basis of an application- cum-declaration in the format given in Appendix G. The AD Category I banks should satisfy themselves that the resident individuals understand the nature of risk inherent in booking of forward contracts and should carry out due diligence regarding “user appropriateness” and “suitability” of the forward contracts to such customer.

B II. General Instructions for forex derivative contracts entered by Residents in India

While the guidelines indicated above govern specific foreign exchange derivatives, certain general principles and safeguards for prudential considerations that are applicable across the OTC foreign exchange derivatives, are detailed below. In addition to the guidelines under the specific foreign exchange derivative product, the general instructions should be followed scrupulously by the users (residents in India other than AD Category I banks) and the market makers (AD Category I banks).

a) In case of all forex derivative transactions [except INR- foreign currency swaps i.e. moving from INR liability to foreign currency liability as in section B para I(1)(iv)] is undertaken, AD Category I banks must take a declaration from the clients that the exposure is unhedged and has not been hedged with another AD Category I bank. The corporates should provide an annual certificate to the AD Category I bank certifying that the derivative transactions are authorized and that the Board (or the equivalent forum in case of partnership or proprietary firms) is aware of the same.
b) In the case of contracted exposure, AD Category I banks must obtain:

i) An undertaking from the customer that the same underlying exposure has not been covered with any other AD Category I bank/s. Where hedging of the same exposure is undertaken in parts, with more than one AD Category I bank, the details of amounts already booked with other AD Category I bank/s should be clearly indicated in the declaration. This undertaking can also be obtained as a part of the deal confirmation.
ii) Quarterly certificates from the statutory auditors of the users, that the contracts outstanding at any point of time with all AD Category I banks during the quarter did not exceed the value of the underlying exposures.

c) Derived foreign exchange exposures are not permitted to be hedged. However, in case of INR- foreign currency swaps, at the inception, the user can enter into one time plain vanilla cross currency option (not involving Rupee) to cap the currency risk.
d) In any derivative contract, the notional amount should not exceed the actual underlying exposure at any point in time. Similarly, the tenor of the derivative contracts should not exceed the tenor of the underlying exposure. The notional amount for the entire transaction over its complete tenor must be calculated and the underlying exposure being hedged must be commensurate with the notional amount of the derivative contract.
e) Only one hedge transaction can be booked against a particular exposure/ part thereof for a given time period.
f) The term sheet for the derivative transactions (except forward contracts) should also necessarily and clearly mention the following:

i) the purpose for the transaction detailing how the product and each of its components help the client in hedging;
ii) the spot rate prevailing at the time of executing the transaction; and
iii) quantified maximum loss/ worst downside in various scenarios.

g) AD Category I banks can offer only those products that they can price independently. This is also applicable to the products offered even on back to back basis. The pricing of all forex derivative products should be locally demonstrable at all times.
h) The market-makers should carry out proper due diligence regarding ‘user appropriateness’ and ‘suitability’ of products before offering derivative products (except forward contracts) to users as detailed in DBOD.No.BP.BC.86/21.04.157/2006-07 dated April 20, 2007.
i) AD Category I may share with the user the various scenario analysis encompassing both the possible upside as well as the downsides and sensitivity analysis identifying the various market parameters that affect the product.
j) The provisions of comprehensive guidelines on Derivatives issued vide DBOD.No.BP.BC. 86/21.04.157/2006-07 dated April 20, 2007 and as amended from time to time are also applicable to forex derivatives.
k) Sharing of information on derivatives between banks is mandatory and as detailed
vide circular DBOD.No.BP.BC.46/08.12.001/2008-09 dated September 19, 2008 and DBOD.No. BP. BC. 94/ 08.12.001/ 2008-09 dated December 8, 2008.

Relevant RBI Circulars in Relation to Forward Contract

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