Use of Derivatives by Indian Exporters

Presentation by FIMMDA to CBI

Foreign Buyer Order/LC For T-Shirts Shipment after 1 year. Price $ 10 per Tshirt

Indian Exporter

Exporters P/L calculations : T-Shirt Cost = Rs 380 + Profit Rs 10 Export Invoice Price : Rs 390 Exchange Rate as on . $ 1 = Rs 39.00 Therefore USD Price per T-Shirt : $ 10

Exporter Request for Forward Contract, Value 1 year forward

Bank A

1 Borrow $ 0.95 Bank X 3 Deposit/Lend Rs 37.05 Bank A

2 Sell $ 0.95 Rs 37.05 4 Receive Maturity Proceeds Rs 39.25 Bank Z Bank Y

Forward Exchange Rate 1 $ = Rs 39.20

Exporter

1$ Bill
1 Borrow $ 0.95

Rs 39.20 ( 39.25- 0.05)

2 Sell $ 0.95 RS 37.05 4 Receive maturity Proceeds incldg Int Rs 39.25

Bank X 6

Bank A

Bank Y

Repay $ 1.00 Loan + Int 3 Lend/Deposit Rs 37.05 Bank Z

Spot Exchange rate 1 $ = Rs 39.00

3 Months later Spot $/INR = Rs 35.00 (say) After the Exporter booking a Forward Contract at 1$ = Rs 39.20 (value 1 year Fwd) Foreign Buyer cancels the order placed with the Exporter

Exporter

Request to cancel Forward Contract

Bank A

Exporter

4 3 Bank X Prepay $ loan + Int = $ 0.96 =(Rs 0.50 ) Break deposit

Rs 2.99 ( Gain to Exporter without making any Exports ! ) Bank A 2 Buy $ 0.96 Rs 33.60 Bank Y

1 Rs+ Int ( 37.59 ) Bank Z

Spot Exch Spot Exch Rate 1 $ Rate : = Rs.35.00 1$=Rs 35.00 1 Gain on Cancellation of Fwd Contract: Rs 37.59- Rs 33.60 = Rs 3.99 Less Interest on $ loan converted into Rs = Rs 0.50 Less Bank As operating Expenses + margin Rs 0.50 Amount payable to Exporter Rs 2.99

3 Months later Spot $/INR = Rs 45.00 (say)

After the Exporter booking a Forward Contract at 1$ = Rs 39.20 (value 1 year Fwd) Foreign Buyer cancels the order placed with the Exporter

Exporter

Request to cancel Forward Contract

Bank A

Exporter

4 3 Bank X Prepay $ loan + Int = $ 0.96 =(Rs 0.50 ) Break deposit

Rs 6.61 ( Loss to Exporter) Buy $ 0.96 Rs 43.20 1 Rs+ Int ( 37.59 ) Bank Z

Bank A

Bank Y

Spot Exch Spot Exch Rate 1 $ Rate : = Rs.35.00 1$=Rs 45.00 1 Loss on Cancellation of Fwd Contract: Rs 37.59- Rs 43.20 = Rs (5.61) Add Interest on $ loan converted into Rs = Rs (0.50) Add Bank As operating Expenses + margin Rs ( 0.50) Amount Payable by the Exporter Rs (6.61)

IN SUMMARY A Forward Contract booked by an Exporter seeks to protect his profitability from his business operations (Export of T-Shirts in the present examples) As long as the Forward Contract is not cancelled, and the contracted export takes place, the Exporter does not make any gains/losses on account of the fluctuations in the foreign currency versus INR (if exports invoiced in foreign currency If a Forward Contract(Exports) is cancelled, there could be a gain for the Exporter , if the foreign currency (vs INR) price depreciates as on date of cancellation as compared to the spot rate on date of booking the contract.

If a Forward Contract(Exports) is cancelled, there could a loss to the Exporter , if the foreign currency (vs INR) price appreciates as on date of cancellation as compared to the spot rate on date of booking the contract.

MOVEMENTS OF USD/INR SPOT RATE DURING THE PERIOD UNDER EXAMINATION

Periods when an Exporter could have GAINED on account of Export Fwd Contract Cancellations : Period _____ USD/INR From To Max Depreciation of USD/INR Max Gains to Exporters (Gross)

5.3.07 26.07.07

44.68

40.87
39.24 39.79

3.81
2.10 0.95 6.86

17.8.07 10.10.07 41.34 17.3.08 - 17.4.08 40.74

Periods when an Exporter could have LOST on account of Export Fwd Contract Cancellations : Period USD/INR _____ 24.7.07- 17.8.07 16.01.08- 17.3.08 17.4.08 - 27.5.08 USD/INR From To 40.24 - 41.34 39.29 40.74 39.78 42.99 Max Depreciation of Max Loss to Exporters (Gross) 1.10 1.45 3.21 5.76

OUR CONTENTION When Forward Contracts were introduced in India, the Gains (if any ) on account of cancellation of Forward Contracts were not passed on by banks to exporters Losses (if any) on account of cancellation of Forward Contracts were passed on to exporters Earlier system prevented Exporters from speculative activity in the foreign exchange market. With Liberalisation, Exporters allowed to get gains on Cancellation of Forward Contracts, which set off part of the losses on cancellations. Emboldened by the profits made by booking and cancelling forward contracts when the foreign currency was depreciating, (against genuine underlying and genuine cancellation of orders), exporters started engaging in speculative Trading Activity, totally un-connected with their core export business. Exporters made multiple bookings under a single order, using the

OUR CONTENTION (Contd ) The Exporters are not innocent and gullible but knowledgeable as they have been in the exports and foreign exchange business much longer than bank officers , (who are in an assignment for not more than 3 to 4 years) While engaging in Trading activities, even a seasoned Foreign Exchange Dealer in a bank makes a loss. But banks have well defined Risk Management policies for cutting losses.

Exporters, while engaging in Trading Activities ( with/ without underlying exports), did not have well defined Risk Management policies, resulting in losses , when the USD and other foreign currencies started appreciating.
Having engaged in these trading activities, the exporters are now blaming innocent bankers of defrauding them !!

Disadvantages of Forward Contracts

Locks an Exporter into a fixed rate of exchange ( 1 $ = Rs 39.00 say ) Exporter has to deliver the underlying whatever may be the Exchange Rate on date of delivery .

Forward Contract

USD/INR as on delivery date

Fx P/L for unhedged Exporter

Fx P/L for hedged exporter1 4

1$ = Rs 39.00

1 $ = Rs 49.00
1 $ = Rs 29.00

+ Rs 10.00
- (Rs 10.00)

Nil
Nil

3. Loss on cancellation , if spot USD/INRhigher than Rs 39.00 on date of cancellation

Advantages in booking Forward Contracts

1. No upfront fees

2. Fx risk due to currency fluctuation completely eliminated

3. Profit on cancellation if spot USD/INR lower than Rs 39.00 on date of cancellation

Options A better hedging tool

PUT OPTION : Gives the buyer (exporter) the RIGHT but not the OBLIGATION to deliver (SELL) the underlying (USD/INR) on a specified future date at a specified exchange rate fixed now (1 $ = Rs39.00 say ) . . CALL OPTION : Gives the buyer (importer) the RIGHT but not the OBLIGATION to take delivery (BUY) underlying (USD/INR) at a specified exchange rate fixed now (1 $ = Rs 39.00 say )

OPTION PREMIUM

The buyer of the option pays an upfront fee (premium) to the seller of the Option

Advantage of Put Options over forward contracts for and Exporter

Forward contract Locks in forward rate (at 1$ = Rs39.00 say ) Unable to enjoy upside ( 1 $ = Rs 49.00 )

Put option The exporter is under no obligation to exercise option and deliver underlying at contracted rate. Will exercise Option and deliver underlying if rate is say 1 $ = Rs 35.00 Will not exercise Option if rate is say 1 $ = Rs 49.00

Disadvantages of Options as compared to Forward Contracts

Forward Contract No uprfront fees for booking contract Put Option >Upfront fees payable , depending on volatility of USD/INR Upside available only if exchange rate exceeds fee/premium for buying the Option. Example : Option Price 1 $ = Rs 39.00 Premium = Rs 2.00 Upside available only if USD/INR exceeds - Rs 41.00

Why did Exporters prefer Zero Cost Option Structures ?

Exporters had been booking Forward Contracts for ages, and there was no fee for buying this hedging product. They did not want to pay the Option premium which would cut into their business profits, as cost of Option could not be loaded on to the foreign buyer

Enter Zero cost Option Structures

Forward Contracts >Down-side risk protected >Upside potential limited to the rate at which forward contract booked > No Upfront Fees >Cost of Put Option set-off by premium received by selling a CALL Option. No net receipt or payment of premium, hence no upfront fees Zero Cost Option Structure >Down side protected with Exporter buying a PUT Option >Upside limited with Exporter writing/selling a CALL Option

Enter Zero cost Option Structures

Forward Contracts Cancellation , when spot is lower than contracted rate, gives profit. Zero Cost Option Structure Cancellation of structure, when spot is lower may not necessarily result in profit, as Exporter would have to buy a matching CALL, and the premium is a function of volatility, and not a linear function. In the case of Exotic Zero Cost structures , the Premium for buying back the CALL, may be much more than the favourable movement of the spot.

Some arithmetic of Forwards and Zero Cost Structures

Forward Contracts Exporter books 3 $ forward at 1 $ = Rs 39.00 On Due Date : 1$ = Rs 49.00 Exporter delivers $ 3 at Rs 39.00 Fx P/L ( Rs 49.00 39.00 ) = Rs 10.00 Zero-Cost Structures Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 39.00 2 $ CALL @ 1 $ = Rs 41.00 On Due date : 1 $ = Rs 49.00 Buyer of CALL excercises option at Rs 41.00 Exporter delivers 2 $ CALL @ 1 $ = Rs 41.00 Exporter does not exercise PUT, and sells underlying 1 $ @ 1 $ = Rs 49.00 Gain on PUT ( 49.00 39.00 ) = 10.00 Loss on CALL ( 49.00- 41.00) = 8.00 Total Loss ( 1 * 10) ( 2*8) = ( 6)

Some arithmetic of Forwards and Zero Cost Structures

Forward Contracts Exporter books 2 $ forward at 1 $ = Rs 39.00 Zero-Cost Structures Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 41.00 2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1$ = Rs 49.00 Exporter delivers $ 2 at Rs 39.00 Fx P/L ( Rs 49.00 39.00 ) = (-)Rs 10.00 Total Fx Loss ( 2 * 10 ) = (-) Rs 20.00

On Due date : 1 $ = Rs 49.00 Buyer of CALL excercises option at Rs 41.00 Exporter delivers 2 $ CALL @ 1 $ = Rs 41.00 Exporter does not exercise PUT Loss on CALL ( 49.00- 41.00) = 8.00 Total Loss ( 2*8) = (-) Rs 16

Some arithmetic of Forwards and Zero Cost Structures

Forward Contracts Exporter books 2 $ forward at 1 $ = Rs 39.00 On Due Date : 1 $ = Rs 29.00 Exporter delivers $ 2 at Rs 39.00 Fx P/L ( Rs 39.00 29.00 ) = + Rs 10.00 Total Profit : ( 2 * 10.00) = + Rs 20.00 Zero-Cost Structures Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 41.00 2 $ CALL @ 1 $ = Rs 41.00 On Due date : 1 $ = Rs 29.00 Buyer of CALL does not excercise option at Rs 41.00 Exporter sells 1 $ unhedged underlying @ 1 $ = Rs 29.00 Exporter exercises PUT, and delivers underlying 1 $ @ 1 $ = Rs 41.00 Gain on PUT (41.00-29.00) = Rs 12.00 Loss on unhedged underlying (39.00 29.00) = Rs 10.00 OR (41.00- 29.00) = RS 12.00 Total Loss: (1 * 12) ( 1 * 12) = (-) Rs 0.00 Or Profit : (1 * 12) (1 * 10) = + Rs 2.00

Conclusions regarding choice between FC and Zero Cost Option

Forward Contract Most advantageous when : Spot Lower than Contracted Rate Least Advantageous When : Spot Higher than Contracted Rate From April 2007 to Oct 2008 USD/INR went up, and contracts booked at 39.00 were in loss. Where there are no underlyings , FX Loss adds to business loss, as corporate has to buy the underlying in the market and deliver. Zero Cost Option Structure Most Advantageous when : Spot Equal to the Forward Contract Rate Least Advantageous when : Spot higher than Strike/Contracted Rate From April 2007 to Oct 2008 USD/INR went up, and ZeroCost Structures booked at 41.00 were in loss

Some arithmetic of Forwards and Zero Cost Structures

Forward Contracts Exporter books 2 $ forward at 1 $ = Rs 39.00 On Due Date : 1 $ = Rs 39.00 Exporter delivers $ 2 at Rs 39.00 Fx P/L ( Rs 39.00 39.00 ) = NIL Total Profit : NIL Zero-Cost Structures Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 41.00 2 $ CALL @ 1 $ = Rs 41.00 On Due date : 1 $ = Rs 39.00 Buyer of CALL does not excercise option at Rs 41.00 Exporter sells 1 $ unhedged underlying @ 1 $ = Rs 39.00 Exporter exercises PUT, and delivers underlying 1 $ @ 1 $ = Rs 41.00 Gain on PUT (41.00-39.00) = Rs 2.00 Loss on unhedged underlying (39.00 39.00) = NIL Total Fx Profit : (2*1) = Rs2.00