Monday, January 15, 2007

foreign currency derivatives revised guidelines

In terms of recently issued guidelines, corporates are now allowed to sell currency options against export receivables or import pay ables. Earlier, they could buy options against their exposures but could not sell. This would allow the exporter get upfront income as he receives premium towards his sale with limited risk as the option is covered by future receivables of the exporter. Also, Indian banks will now be allowed to run cross currency option books. Caps and floors are structured combinations using interest rate options – both calls and puts. A cap would imply an upper limit on the interest rate and floor would be the lower limit. Selling call options allows a corporate to create a cap, while buying put options on interest rates creates a floor for the corporate. Here the options are linked to a benchmark reference rate like the LIBOR.  Suppose a corporate sells a call option for $1 million at a strike of 6.50%. If LIBOR goes below 6.50%, the option holder would exercise the option, allowing him to earn a rate that is higher than LIBOR. This increases the payout for the corporate, while the LIBOR ensures that he has a floor of 6.50%. This would be the minimum amount that he would have to pay even if interest rates move below 6.50%. Selling call options also helps reduce the overall transaction cost as the corporate receives a premium for the sale of options. Buying put options helps the corporate create a cap on the highest rate of interest to be paid out. Continuing with the previous example, instead of selling, the client buys put options at a strike of 6.50%. So, if LIBOR rises beyond 6.50%, the corporate exercises the option and pays lower rates capping his upper limit on interest rates. Again, the corporate needs to pay a premium for purchasing the cap. A combination of floors and cap is called a collar.


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