FORWARD AND OPTIONS CONTRACT
A foreign exchange transaction involves exchange of one currency with another by the counter parties to the transaction. The date on which such an exchange takes place is called the value date of the transaction.
There are four categories of value dates:
Cash transaction: value date is today
Tom transaction: short form for tomorrow. Value date is tomorrow or the next working day
Spot transaction: value date is two working days from today
Forward transaction: value date is any working day beyond (after) the spot date
A foreign exchange contract to buy or sell a particular currency against another at a pre-determined exchange rate for an agreed future date or period. Such a contract is obligatory and binding. In simple terms, it is the fixing of a volatile exchange rate for a future date or period.
Any resident Indian (including NRIs), companies, firms, corporations, etc. exposed to genuine foreign exchange risk can book a foreign exchange forward contract. Such forward contracts are usually booked by exporters, importers, NRIs and FIIs (foreign institutional investors). The Reserve Bank of India regularly liaison Foreign Exchange Dealers Association of India (FEDAI) for framing rules and regulations regarding all foreign exchange transactions.
A currency option is a financial instrument in which the buyer of the option has the right and not the obligation to exchange one currency into another currency at a pre-determined exchange rate on a specified future date/period (called expiration date/period or maturity date/period). To acquire this right, the buyer pays to the seller of the option a fee called the option premium/option price. The fee is paid upfront at the time of buying the option.
The pre-determined exchange rate is called the strike price or exercise price.
Right to buy the currency is called a Call Option.
Right to sell the currency is called a Put Option.
European options can be exercised on the date of maturity only while an American option can be exercised on any working day till the maturity date.
FOREX MARKET SPECIFICATIONS
Forward premiums/discounts on exchange rates arise due to the difference of interest rate of the two countries.
For fully convertible currencies, premiums/discounts are completely dependent on the interest rate differentials. For example, EURUSD forward premiums are dependent on the interest rates of Eurozone and the US. Currency with lower interest rate will be at a premium to the currency with higher interest rate.
For partially convertible currencies like USDINR, in addition to interest rate differentials, forward dollar demand/supply and Central Bank actions also play a part.
Telegraphic Transfer (TT) is one of the commonest methods for transferring remittances abroad. In this method, the buyer pays the amount of remittance in his country’s currency to his banker who in turn will convert the remittance to the currency of the seller and transmit the coded payment amount. Examples of transactions where TT rate is applied include payment or receipt of demand drafts, mail transfers, Telegraphic transfers etc. drawn on the bank.
TT buying rate: This rate is applied for purchase of foreign currency by banks (or selling of foreign currency by customer). It is applied to a transaction that does not involve any delay in realisation of foreign exchange by the bank. The rate is calculated by deducting from the interbank buying rate the exchange margin. Thus, all foreign inward remittances which are made payable in India are converted by applying this rate.
TT Selling rate: This rate is applied for selling foreign currency to the customer by the bank for effecting remittances outside India. This rate is calculated by adding exchange margin to the interbank selling rate. TT rate is used for all transactions that do not involve handling of documents by the bank.
Bill buying or selling by any bank involves handling of export/import documents by the bank. Since some time and effort of the bank staff are invested, the rate offered is usually worse than the TT rate. Additionally, the bank will charge interest for the time period it has lent the funds.
Bill buying rate: This is the rate applied when a foreign bill is purchased/negotiated/discounted. When a bill is purchased, the proceeds will be realised by the bank after the bill is presented to the drawee at the overseas centre. In the case of a usance bill, the proceeds will be realised on the due date of the bill, which includes the transit period and the usance period of the bill.
Bill selling rate: This rate is to be applied for transaction involving transfer of proceeds of import bills. Even if the proceeds of import bills are remitted in foreign currency by way of demand draft, import documents, pay orders, money transfer, etc. the rate to be applied is the bill selling rate.
There is no standard formula for deciding on margins on inter-bank rates, but it usually depends on the size of the transaction, customer relationship with the bank and the customer’s awareness about forex rates. FEDAI (Foreign Exchange Dealers Association of India) had given detailed guidelines for computing various forex rates. Base rate is a rate that forms the basis of computation of spot rates. The base rate selected by the Authorised Dealers should be in line with the ongoing market rates.
The Authorised Dealers can load profit margins as under:
TT Buying – 0.025% to 0.080%
Bill Buying – 0.125% to 0.150%
TT Selling – 0.125% to 0.150%
Bill Selling – 0.175% to 0.200% (on TT selling rate)
The above margins are the maximum margins that banks can charge but are negotiable.
Please Note: The guidelines regarding margins have been withdrawn by FEDAI and the banks are free to load margins as per their discretion subject to the conditions that the spread between TT buying and TT selling rate is within the limits prescribed by it.
Nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country’s currency exchanges for a basket of multiple foreign currencies. In economics, the NEER is an indicator of a country’s international competitiveness in terms of the forex market. Forex traders refer to the NEER as the trade-weighted currency index.
If the NEER is adjusted to compensate for the inflation rate of the home country relative to the inflation rates of its trading partners, the resulting figure is the real effective exchange rate (REER).
Unlike the relationships in a nominal exchange rate, NEER is not determined for each currency separately. Instead, one individual number, typically an index, expresses how a domestic currency’s value compares against multiple foreign currencies at once.
If a domestic currency increases against a basket of other currencies inside a floating exchange rate regime, NEER is said to appreciate. If the domestic currency falls against the basket, the NEER depreciates.
EXPORT / IMPORT FINANCING
Commercial banks provide financial support to exporters in the form of working capital for procurement of raw material, processing, packaging, transportation, ware-housing etc. of goods meant for export. If the financing is done before the shipment of goods, it is called pre-shipment finance. Such a financing is also called Packing Credit (PC).
Financial assistance provided by commercial banks after the shipment of goods is called post shipment finance. It is provided for bridging the gap between shipment of goods and realisation of export proceeds. Post shipment finance is done by purchasing or negotiating the export documents or by extending advance against export bills accepted on collection basis. This financing is commonly called export bill discounting.
Packing Credit in Foreign Currency (PCFC) is a form of an export credit that exporters can avail for working capital requirements. It is a dollar credit and hence interest rates are LIBOR based. Conversions of dollar to rupees happen when PCFC is taken (or availed). The inward (export) remittances received by the exporter are set off with the outstanding PCFC amounts.
An exporter can take packing credit in Indian rupee also. Since Nov 2015, Government of India has introduced an interest subvention scheme of 3% on Pre-Shipment and Post-Shipment rupee export credit. The scheme would be available to all exports of MSME and 416 tariff lines. Scheme would not be available to merchant exporters.
FCNR (B) loans are a source of short term funding available to corporates. Out of the resources mobilised by the banks under the FCNR (B) scheme, banks have been permitted to provide foreign currency denominated loans to their customers. Banks decide the purpose, tenor and interest rates on such loans. While the introduction of the scheme has placed cheap credit at the disposal of Indian corporates (as interest rates are linked to USD LIBOR), the foreign exchange risk is borne by the corporate who has availed the loan.
Following are the detailed cost particulars of a 6 months FCNR (B) loan:
|Loan drawdown date||3 November 2017|
|Bank’s Spread *||2.00|
|Hedging Cost (Annualized)||4.58%|
Bank’s Spread will depend upon the credit rating of the corporate.
Buyer credit is a short term credit available to an importer (buyer) from overseas lenders such as banks and other financial institution for goods they are importing. The overseas banks usually lend the importer (buyer) based on the letter of comfort (a bank guarantee) issued by the importer’s bank. For this service the importer’s bank or buyer’s credit consultant charges a fee called an arrangement fee.
Buyer’s credit helps local importers gain access to cheaper foreign funds that may be closer to LIBOR rates as against local sources of funding which are more costly.
The duration of buyer’s credit may vary from country to country, as per the local regulations. For example, in India, buyer’s credit can be availed for one year in case the import is for tradable goods and for three years if the import is for capital goods.
The following benefits accrue to an importer for availing buyers’ credit:
- The exporter gets paid on the due date, whereas importer gets extended date for making an import payment as per the cash flows
- The importer can deal with exporter on sight basis, negotiate a better discount and use the buyers credit route to avail import financing
- The funding currency can be depending on the choice of the customer and availability of LIBOR rates in the exchange market
- The importer can use this financing for any form of payment mode; open account, collections, or LCs.
Currency risk arises on availing buyers’ credit since foreign currency is involved. As such, currency risk management practices should be in place to protect from adverse currency volatility.
Exporters of goods and services and beneficiaries of inward remittances can open a foreign currency account with their designated banks (Authorised Dealer category) called an Exchange Earners’ Foreign Currency Account.
The following benefits can be availed by an EEFC account holder:
- An exporter can use his EEFC balances to pay for imports, thereby reducing forex risk as well as saving currency conversion charges.
- One can use EEFC balances to avail credits on his foreign currency travel card, minimizing transaction costs.
Resident Indians, who are foreign currency earners, are eligible to open an EEFC account. It can be individuals, companies, etc. In simple words, any foreign currency earner can open an EEFC account.
No interest is payables on EEFC balances. Cheque facility is available for EEFC account operation.
Entire foreign currency earnings can be credited to the EEFC account. There are limits to holding these foreign currency balances in the EEFC account. All foreign currency receipts in the EEFC account, received in a calendar month has to be converted to Indian Rupees before the end of the next calendar month.
Foreign currency account balances in EEFC can be hedged by doing a forward contract. The amount hedged has to be set aside for delivery. Forward contract rollovers are also permitted.
Convertibility of a currency may be defined as the freedom to convert one currency into any other internationally accepted currency. There are two forms of currency convertibility – current account convertibility and capital account convertibility. Full currency convertibility indicates the absence of exchange controls or restrictions on any foreign exchange transaction. Indian Rupee is convertible only on the current account and not on the capital account.
Current account convertibility has been defined as the freedom to buy or sell foreign exchange for:
- International transactions consisting of payments due to foreign trade, other current businesses including services and normal short-term banking and credit facilities
- Payments due as interest on loans and as net income from other investments
- Payment of moderate amounts of amortisation of loans for depreciation of direct investments
- Moderate remittances for family living expenses
- Business travel, participation in overseas conferences/seminars, studies/study tours abroad, medical treatment/check-up and specialised apprenticeship training.
Capital account convertibility (CAC) means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. This implies that capital account convertibility allows anyone to freely move from local currency into foreign currency and vice versa. Capital account convertibility indicates that the home currency can be freely converted into foreign currencies for acquisition of capital/physical assets abroad.
RBI guidelines in this regard are as under:
- RBI should have accorded final approval for the conclusion of the underlying loan.
- The notional principal amount of the hedge should not exceed the outstanding amount of the foreign currency loan.
- The maturity of the hedge should not exceed the remaining life to maturity of the underlying loan.
- The Board of Directors of the corporate should have drawn up a risk management policy laying down clear guidelines for concluding transactions, and institutionalising arrangements for a quarterly review of operations and annual audit of transactions to verify compliance with the regulations.
- The hedge should result in reduction of the risk of exposure and there should be no net inflow of premium direct or implied incases where the option components are built into the hedge strategy.
- Corporates may be permitted to unwind a hedge transaction.
- A report of the transaction (booked/cancelled), verified by the authorised dealer should be submitted to the concerned Regional Office of the Reserve Bank, within a week of its conclusion.
- Authorised dealers should obtain from the concerned corporates copies of the quarterly reviews and annual audit reports.
- Payment of upfront premia, if any, as well as all other charges incidental to the hedge transaction may be effected without the prior approval of RBI.
- Only resident customers having genuine exposure can book foreign currency option contracts. This product may be freely booked and cancelled.
- Banks should obtain a request letter from the customer as per specimen provided by FEDAI which inter-alia contains a declaration that there is already no forward exchange cover or foreign currency option in place against the exposure.
- The customer should communicate notice of exercise of option contract two working days in advance before the delivery date as provided in the International Currency Option Market (ICOM) and should exercise the option before 4 pm IST on the date of exercise. Notice of exercise cannot be given by facsimile transmission.
- Foreign currency option can be concluded only Over the Counter (OTC)
- Banks may write options in respect of customer transactions and cover themselves with the overseas branches/correspondent banks accordingly.
- Option premium may be paid and received in foreign exchange. In the case of premiums on options bought by Authorised Dealers they may charge the premium to the customer by keeping a spread.
- The factors that should be reckoned for determining the premium amount are strike price, maturity period of the contract, expected currency volatility, interest rate differentials and market conditions.
- The premium amount once collected is not refundable.
- Option should be written only on a fully covered basis. i.e. Option positions should not be left open.
- Option premium may be remitted without the prior approval of the Reserve Bank.
- Appropriate accounting entries should be passed for options bought and sold and premiums amount received and paid. Option exposure should appear in the accounts as a contingent item.
The Asian Clearing Union (ACU) was established with its head-quarters at Tehran, Iran, on December 9, 1974 at the initiative of the United Nations Economic and Social Commission for Asia and Pacific (ESCAP), for promoting regional co-operation. The main objective of the clearing union is to facilitate payments among member countries for eligible transactions on a multilateral basis, thereby economizing on the use of foreign exchange reserves and transfer costs, as well as promoting trade among the participating countries.
The Central Banks and the Monetary Authorities of Bangladesh, Bhutan, India, Iran, Maldives, Myanmar, Nepal, Pakistan and Sri Lanka are currently the members of the ACU.
All transactions to be settled through the ACU will be handled by AD Category-I banks in the same manner as other normal foreign exchange transactions, through correspondent arrangements.
The Asian Monetary Units (AMUs) is the common unit of account of ACU and is denominated as ‘ACU Dollar’ and ‘ACU Euro’, which is equivalent in value to one US Dollar and one Euro respectively. All instruments of payments under ACU have to be denominated in AMUs. Settlement of such instruments may be made by AD Category-I banks through the ACU Dollar Accounts and ACU Euro Accounts, which should be distinct from the other US Dollar and Euro accounts respectively maintained for non ACU transactions. As the payment channel for processing ‘ACU Euro’ is under review, the operations in ‘ACU Euro’ have been temporarily suspended with effect from July 01, 2016 and accordingly, all eligible current account transactions including trade transactions in “Euro” are permitted to be settled outside the ACU mechanism until further notice.
Majority of transactions, as possible, should be settled directly through the accounts maintained by AD Category-l banks with banks in the other participating countries and vice versa; only the spill-overs in either direction are required to be settled by the Central Banks in the countries concerned through the Clearing Union. At all times, the balances maintained in the ACU Dollar and ACU Euro accounts should be commensurate with requirements of the normal business. With effect from July 01, 2016, all eligible current account transactions including trade transactions in “Euro” are permitted to be settled outside the ACU mechanism until further notice.
AD Category-l banks are permitted to settle commercial and other eligible transactions in much the same manner as other normal foreign exchange transactions.
Yes, this is permissible. With effect from July 01, 2016, all eligible current account transactions including trade transactions in “Euro” are permitted to be settled outside the ACU mechanism until further notice.
The following payments are eligible to be settled through ACU:-
- for export/import transaction between ACU member countries on deferred payment terms
- not declared ineligible as mentioned under the next question
Note:- Trade transaction with Myanmar may be settled in any freely convertible currency, in addition to the ACU mechanism.
The following payments are not eligible to be settled through ACU:-
- Payments between Nepal and India and Bhutan and India, exception being made in the case of goods imported from India by an importer resident in Nepal who has been permitted by the Nepal Rastra Bank to make payments in foreign exchange. Such payments may be settled outside ACU mechanism
- Payments that are not on account of export / import transactions between ACU members countries except to the extent mutually agreed upon between the Reserve Bank and the other participants
- All eligible current account transactions including trade transactions with Iran should be settled in any permitted currency outside the ACU mechanism until further notice.
Yes – except the transactions mentioned in the question above. However, trade transactions with Myanmar may be settled in any freely convertible currency, in addition to the ACU mechanism. Further, with effect from July 1, 2016, all eligible current account transactions including trade transactions in “Euro” are permitted to be settled outside the ACU mechanism till further notice.