Underlining the Underlying Exposure

The RBI requires anyone trading in currency derivatives to have an underlying exposure to forex. It seems many market participants were not aware of this. So, the RBI recently reinforced this requirement through a recent circular.

The deadline to ensure that users participating in currency derivatives have an underlying exposure was set at 05 April 2024. With confusion persisting among investors, the RBI has now moved the deadline to 03 May 2024.

That begs the question, what is an underlying exposure?

Let’s say you have a USD-denominated cash outflow or liability arising in three months. To avoid any effects of forex fluctuations, you hedge it by buying a three-month USD futures contract. Here, the USD-denominated liability or cash outflow is your underlying exposure. The RBI says you must have such an underlying exposure to participate in currency derivatives.

A following question – what kind of exposures could be considered as “underlying exposure or contracted exposure to foreign currency?” You could be invested in gold or silver, which are influenced by foreign exchange rates. However, they are also influenced by several other factors. 

So, do gold and silver qualify as “exposure to foreign currency?” Can you engage in currency derivatives trading on the basis of having invested in gold? Not really.

Like most others, we are also trying to make sense of what could or could not be considered as underlying exposure. I will try and answer a few common queries I came across on the internet. 🙂

Here goes!

Q: I export/import goods to/from foreign countries through my partnership firm. Can I use my export and import contracts as an underlying exposure to participate in currency derivatives?

A: Your firm can participate in currency derivatives, but you personally cannot. Your firm’s participation should be meant to hedge your export or import contract. So, the transaction size has to be about the size of the contract.

Q: I am invested in stocks and ETFs (Apple,Google, Microsoft, SPY etc.) listed on the New York Stock Exchange. Am I allowed to hedge these investments in India through currency derivatives?

A: Yes, you are allowed to hedge investments made on foreign exchanges.

Q: I am invested in the Indian IT and oil stocks. Indian IT depends a lot on foreign revenues. Oil companies rely on foreign countries to source oil and gas. Clearly, their performance is impacted by fluctuations in forex. So, can I hedge these investments in the currency derivative segment?

A: No, you can’t. While IT and oil companies maintain a treasury division to hedge their forex exposure, you cannot treat your investment in these companies as forex exposure to hedge in the currency derivatives market.

Q: I have units of an Indian mutual fund/ETF that invests in Chinese and American equities (Apple, Google, Tencent, Alibaba, etc). Can I consider these as contracted exposures to foreign currency to participate in currency derivatives?

A: It appears you can, but you must consult with a FEMA expert. While this is not a current or capital account transaction as per FEMA regulations, the regulations consider it to be a contracted exposure if the transaction is linked to a foreign currency or foreign benchmark. These mutual funds are linked to a foreign currency or foreign benchmark. 

Q: I have units of a Singapore / US based mutual fund. Does it count as underlying exposure?

A: Yes, it does. Since you will invest in these mutual funds using foreign currency, you have a direct exposure to forex. Direct forex exposures can be hedged using currency derivatives.

Q: I have derivative contracts on a foreign exchange. Can I hedge those in the Indian currency derivatives market?

A: Yes, derivative contracts on a foreign exchange are a capital account transaction. FEMA regulations consider capital account transactions as “contracted exposure”. So, you can hedge them.

Q: I want to send money to my son/daughter studying at a foreign university. My son/daughter residing in a foreign country will send me money next month. Can I hedge these positions through currency derivatives?

A: Yes. You have a direct exposure to foreign currency in these cases. Therefore, you can hedge them using currency derivatives.

Q: I am an employee of an MNC in India. This MNC is listed in the US. As part of my remuneration, my company has given me employee stocks options (ESOPs) / restricted stock units (RSUs). Can I use these as underlying exposure for participating in currency derivatives?

A: ESOPs and RSUs may not be securities but are contracts with exposure to foreign currency risk. Unless a specific definition is separately issued by the stock exchanges or RBI, it seems fair to include them as contracts that can be hedged.

Q: I have foreign currency in my bank account / at home. Will that be considered an underlying exposure if I want to trade in currency derivatives?

A: Yes, it can be used as an underlying exposure.

While we collated this list of Q&As based on our discussions with subject matter experts across banks and other institutions, it is not exhaustive. There could be several other situations where you might want clarity. It is better to err on the side of caution. Please confirm with a FEMA expert before participating in currency derivatives.

You don’t want to be in the crosshairs of FEMA regulations. 🙂