Background

The Reserve Bank of India (RBI) prescribes permitted products and operational guidelines for Over the Counter (OTC) foreign exchange derivative contracts that can be transacted by various categories of persons resident in India, for hedging different categories of foreign exchange exposures. Such derivatives include foreign exchange forward contracts, foreign currency-INR options, cross currency options and cross currency swaps.

Under the present regulatory framework, outlined in RBI’s Comprehensive Guidelines on OTC Foreign Exchange Derivatives and Overseas Hedging of Commodity Price and Freight Risks (A.P (DIR Series) circular no. 32 dated 28 December 2010), writing of options by users (Indian resident entities) on a stand-alone basis is not permitted. The users could currently enter into option strategies of simultaneous buying and selling of plain vanilla European options, provided there is no net receipt of premium.

New development

With the view to encourage participation in the OTC currency options market and improve its liquidity, RBI through its Circular-RBI/2015-16/431 (the RBI
Circular), issued on 23 June 2016, has permitted resident exporters and
importers of goods and services to write (sell) standalone plain vanilla
European call or put option contracts against their contracted exposure, i.e.
covered call or covered put respectively, to any AD Category-I bank in India
subject to the prescribed operational guidelines, terms and conditions.

Some of the salient features of the RBI Circular are as follows:

• Participants: The guidelines in the RBI circular will be applicable to the following participants:
  • Market makers - AD Category-I banks in India who have RBI’s approval to run cross currency and foreign currency-Indian rupee option books. 
  • Users - Listed companies and their subsidiaries/joint ventures/associates having common treasury and consolidated balance sheet or unlisted companies with a minimum net worth of INR200 crore, if these companies provide appropriate disclosures in the financial statements as prescribed by the Institute of Chartered Accountants of India (ICAI).

• Permitted options: Covered options (either as a single FCY-INR option or as separate options for the FCY-USD and USD-INR legs) may be written (sold) by resident exporter or importers against their underlying contracted exposures arising out of their exports or imports, respectively. However, the use of covered option shall not be considered as a hedging strategy.

• Underlying: Covered options may be written against either a portion or the full value of the underlying. 

• Structure derivative product: The covered option being a combination of an underlying cash instrument and a generic derivative product, should be treated as a structured derivative product.

• Approvals: AD Category-I banks may enter into covered options with their exporter or importer constituents only after obtaining specific approval in this regard from their competent authority, i.e. their Board, Risk Committee, etc.

• Capital and provisioning requirements: AD Category-I banks shall treat the exposures against which a covered option has been written as an ‘unhedged exposure’ and accordingly apply the guidelines on Capital and Provisioning Requirements for Exposures to entities with Unhedged Foreign Currency Exposure.

• Period: Covered option contracts may be written for a maximum maturity period of 12 months. 

 Similar amendments have been made in the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000.

Our comments

A company that writes a call or put option hasthe obligation, but not the right to sell or buy foreign currency, respectively, at the option price, on exercise of the option by the buyer. While RBI’s move is expected to improve liquidity in the OTC currency options market, companies that are proposing to write these options should carefully assess the accounting implications of these options. For instance, the European call or put options are not generally capable of being treated as hedging instruments under current accounting principles.

Also, these options will generally not qualify for hedge accounting under Indian Accounting Standard (Ind AS) 109, Financial Instruments. The covered options would generally, therefore, be recognised at their fair value with changes in fair value recognised through the statement of profit and loss by the issuing companies, under current accounting principles as well as under Ind AS.

To access the text of the RBI circular, please click here.