By Nimesh Vora
MUMBAI (Reuters) – A few large Indian companies are returning to exotic currency options to deal with the rupee’s volatility as they look to manage hedging costs and foreign exchange risks.
These options provide companies increased flexibility to manage their currency risks.
Companies are specifically turning to barrier options, a class of knock-out or knock-in options that are exercisable or expire worthless depending on whether a particular level on the underlying asset is reached.
The Reserve Bank of India had in January lifted a ban on the use of these options after companies incurred sizeable losses on them in 2007-2008. The central bank then set a minimum net worth criteria for companies that can access these exotic products.
One of India’s biggest IT companies is using this tool to manage the cost of options it uses to hedge the dollar payments that are due, an executive, who did not wish to be identified or name the company, told Reuters.
The company is adding barriers to the option structure that it normally does to manage the dollar receivables, the executive said, adding that it is using European knock-in option to manage the costs of the range forward options used to hedge.
Whether a European knock-in barrier option is exercisable or not will depend on the price of the underlying asset at the expiry date.
Range forward is an option strategy that allows exporters to set a predetermined price range at which they will be able to sell dollars on a particular date.
By adding a knock-in option, the exporter can manage the strike price and premium paid, depending on the view on the rupee and hedging needs.
Indian IT companies earn bulk of their revenue from the U.S. and Europe and are highly vulnerable to the fluctuations in currencies.
The use of these barrier options comes in the wake of increased volatility in the rupee. The local currency dropped below 83 to the dollar to a record low last month. The rupee’s fall prompted OTC volatility levels, a key input in pricing options, to rise.
When used with proper risk assessment, barrier options help to manage the premium cost, a trader with a large private sector bank said.
“Both importers and exporters can manage the cost by choosing a particular knock-in level, (depending on their rupee outlook),”
However, the risk is that if the price of the knock-in option is not reached, the customer will be unhedged at the time of expiry, the trader said.
Another banker said that clients who are using options are doing it on a portfolio basis and only a small portion of their hedges via exotic products.
According to a BIS survey, out of the total daily forex average volume of $53 billion in April, only $1.1 billion was in options, while outright forwards were almost eight times that.
Meanwhile, foreign exchange consultants warned against large-scale use of exotic options.
“Companies should consider the additional risks that the barrier options bring and whether it suits their overall hedging strategy,” said Kunal Kurani, associate vice president at Mecklai Financial.
“These kinds of options should never be more than a few percentage points of the total hedging book.”
(Reporting by Nimesh Vora; Editing by Dhanya Ann Thoppil)
