Rupee option sellers in a jam

$500 million contracts cancelled in a week after currency sinks.

Volatility in the foreign exchange market has caught currency options sellers on the wrong foot. The market is witnessing a slew of cancellations of currency options as the spot rupee depreciated by about 2 per cent in October.

The rupee slipped close to 45 to a dollar yesterday but recovered to close at 44.85 today with public sector banks selling dollars on behalf of the Reserve Bank of India.

Foreign exchange dealers said players in currency options dealing with 'advantage forwards' or 'ratio range forward options' had been hit hard. Since last week, there have been cancellations of such contracts worth close to $500 million.

The 'advantage forward' product was lapped by exporters in July when the spot rupee touched 43.20 to a dollar immediately after the revaluation of the Chinese yuan.

This contract specifies that an exporter buying the option will sell its dollar receivables at a future date""one month to one year and even a longer term, depending on the maturity of the contract""at a rate set on the date of contract.

Normally, there is a range of rupee movements allowed in these contracts. If the spot rupee depreciates faster and breaches the range, the exporter is required to sell twice, thrice or even five times the agreed amount.

For instance, in July, when the outlook on the rupee was bullish and a section of the market was expecting the rupee to strengthen to 42 to a dollar, exporters got into 'advantage forward options' at a rate of, say, 44.20 to a dollar to get a better value for future receivables.

The range specified in their contract could be 44.20-44.50. Once the rupee breaches the 44.50 level""which it has done ""they need to sell twice, thrice or five times the amount of the contract.

They can either cancel the contracts at a cost or surrender their future receivables to meet the obligation.

Some of them even need to buy from the market to meet their commitments.

In a forward contract, the seller has the right and obligation to sell dollars at a pre-determined rate, irrespective of the spot rate at that time. However, in an option, the seller has the right, but no obligation, to sell. He can always cancel the option at a cost.

These contracts are also called zero-cost contracts as banks do not charge any premium upfront. Normally, banks charge between Rs 250 and Rs 1,000 for forward contracts and the premium for vanilla options could be between 1 and 2.5 per cent of the value of the contracted amount.

'These are leveraged deals. Some exporters entered into such deals as they wanted higher rupee valuations for their dollar receivables when the outlook on the dollar was bleak. With the sudden spike in the rupee, they are now caught in a bind. If they cancel such contracts, they will incur a cost. The other alternative is to surrender their future receivables or buy dollars from the market to meet the commitment,' a foreign exchange dealer said.

LOOKING FORWARD

• What is 'advantage forward'? An option where an exporter commits to sell dollars at a future date. The contract outlines a range of the rupee's movement and if the currency breaches the range, the exporter needs to sell twice, thrice or even five times the agreed amount
• What can a exporter do if the range is breached? He can cancel the contract at a cost or surrender his future dollar receivables to meet the commitment
• Why do exporters go in for such contracts? They ensure a higher rupee value for their dollar receivables