International Finance Project

Non-Deliverable Forwards & Foreign Currency Exchangeable Bonds

T.Y.B.M.S. - B N.M.College

International Finance Semester 6

Non-Deliverable Forwards
A non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional/principal amount. It is used in various markets such as foreign exchange and commodities. NDFs are prevalent in some countries where forward FX trading has been banned by the government (usually as a means to prevent exchange rate volatility). In India the NDF as an instrument is used to bet on the Indian Rupee. It is a forward contract which is settled in USD, in accordance with the RBI reference rate on the maturity date. An Example of a NDF transaction: Re-$ NDF for 38 million Rupees with a price of Rs.38 On maturity spot rate (RBI) turns out to be 39 Party short on $ loses Re 1 per $ or Rs 1m = $ 25,600 Contract settled by the buyer of Re paying the seller $25,600 The NDF Market The NDF market is an over-the-counter market, where the transaction takes place directly between the parties involved. NDFs began to trade actively in the 1990s. NDF markets developed for emerging markets with capital controls, where the currencies could not be delivered offshore. Most NDFs are cash settled in US dollars.

The Clientele for the NDF markets include, Arbitrageurs who have dollars offshore and access to Indian currency markets i.e. Indian exporters and also Currency hedge funds speculating on the INR. The Markets are Primarily in Singapore and Hong Kong with Dubai and Bahrain showing some activity.

Major global banks involved are, Deutsche Bank, UBS AG, Standard Chartered Bank, Citibank, JP Morgan Chase, ABN Amro, Barclays, ANZ Investment bank, BNP. Indian banks not allowed by RBI.

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T.Y.B.M.S. - B N.M.College How it Began

International Finance Semester 6

Capital flow to emerging market economies (EMEs), particularly Asia, rose significantly during the 1980s and 1990s. During this period, however, while in some EMEs domestic forward markets were not developed, others were characterized by restrictions on non-residents access to domestic forward market. The objective was clear. Local monetary authorities feared that easy access to onshore local currency loans and deposits, and the ability to easily transfer local currencies to non-residents, encourages speculative financial movements, greater exchange rate volatility, and ultimately some loss of monetary control (Higgins and Humpage, 2005). Consequently, some international banks, starting from the early 1990s, began offering non-deliverable forward contracts to investors to hedge their exposures in EME currencies. Structure and Features An NDF is a short-term, cash-settled currency forward between two counterparties. On the contracted settlement date, the profit or loss is adjusted between the two counterparties based on the difference between the contracted NDF rate and the prevailing spot FX rates on an agreed notional amount. The features of an NDF include:

The notional amount: This is the "face value" of the NDF, which is agreed between the two counterparties. There is never any intention to exchange the notional amounts in the two currencies The fixing date: This is the day and time whereby the comparison between the NDF rate and the prevailing spot rate (RBI) is made. The settlement (or delivery) date: This is the day when the difference is paid or received. Depending on the currencies dealt, the fixing date is one or two good business days before the settlement date. The contracted NDF rate: This is the rate agreed between the two counterparties on the transaction date, and is essentially the outright forward rate of the currencies dealt. The prevailing spot rate: The fixing of spot rate on the fixing date is based on the RBI reference rate.

Thus, the only exchange of cash flows is the difference between the NDF rate and the prevailing spot market rate (on the settlement date). This characteristic makes the NDF instrument possess relatively less risk compared to some other instruments. NDF Market Regulation 3|Page

T.Y.B.M.S. - B N.M.College

International Finance Semester 6

At present, there are no controls on the offshore participation in INR NDF markets. The onshore financial institutions in India, however, are not allowed to transact in the NDF markets.

Pricing and Valuation An investor enters into a forward agreement to purchase a notional amount, N, of the base currency at the contracted forward rate, F, and would pay NF units of the quoted currency. On the fixing date, that investor would theoretically be able to sell the notional amount, N, of the base currency at the prevailing spot rate, S, earning NS units of the quoted currency. Therefore, the profit, , on this trade in terms of the base currency, is given by:

Policy Implications of NDF market Markets for non-deliverable currency forwards (NDFs) are of interest to policy makers because, Generally used to hedge exposure or speculate on a currency movement where local market authorities limit such activity. Also a useful tool for market monitoring in that these prices reflect market expectations, and supply and demand factors. Useful informational tool for authorities and investors to gauge market expectations of potential pressures on the exchange rate in future. The relatively low turnover and marginal volatility spillover impact, however, discounts for the need of regulatory control on these markets.Looking forward, India is expected to remain an attractive destination for foreign investors in near future. Consequently, transactions in NDF market may rise to hedge against rupee exposure.

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T.Y.B.M.S. - B N.M.College

International Finance Semester 6

Foreign Currency Exchangeable Bond

Foreign Exchange Developments - September 2008 (i) Direct Receipt of Import Bills / Documents -Liberalisation (ii) Overseas Investment -Rationalisation (iii) Advance Remittance for Import of Services (iv) External Commercial Borrowings (ECB) (v) Issue of Foreign Currency Exchangeable Bonds (FCEB) Scheme, 2008 - Operationalised with effect from September 23, 2008. Definitions as under the Issue of Foreign Currency Exchangeable Bonds Scheme, 2008 Foreign Currency Exchangeable Bond A bond expressed in foreign currency, the principal and interest in respect of which is payable in foreign currency issued by an Issuing Company and

subscribed to by a person who is a resident outside India in foreign currency and exchangeable into equity share of another company, to be called the Offered Company, in any manner, either wholly, or partly or on the basis of any equity related warrants attached to debt instruments.

Issuing Company An Indian company as defined in the Companies Act, 1956, is eligible to issue Foreign Currency Exchangeable Bond. Offered Company An Indian company as defined in the Companies Act, 1956 whose equity share/s shall be offered in exchange of the Foreign Currency Exchangeable Bond. Promoter Group As defined in the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000 includes: a. Promoter - The person/s that are in overall control of the company, the person/s who are instrumental in the formulation of a plan or program pursuant the securities are offered to the public or the person/s named in the prospectus. b. immediate relative of the promoter 5|Page

T.Y.B.M.S. - B N.M.College c. in case, promoter is a company d. in case, promoter is an individual

International Finance Semester 6

Eligibility Conditions and subscription of Foreign Currency Exchangeable Bonds (1) The Issuing Company shall be part of the promoter group of the Offered Company and shall hold the equity share/s being offered at the time of issuance of Foreign Currency Exchangeable Bond. (2) The Offered Company shall be a listed company which is engaged in a sector eligible to receive Foreign Direct Investment and eligible to issue or avail of Foreign Currency Convertible Bond or External Commercial Borrowings. (3) The subscriber shall comply with the Foreign Direct Investment policy and adhere to the sectoral caps at the time of issuance of Foreign Currency Exchangeable Bond. (4) An Indian Company, which is not eligible to raise funds from the Indian securities market, (including a company which has been restrained from accessing the securities market by the SEBI) shall not be eligible to issue Foreign Currency Exchangeable Bond. Entities prohibited to buy, sell or deal in securities by Securities and Exchange Board of India will not be eligible to subscribe to Foreign Currency Exchangeable Bond. Mandatory Requirements (1) The Issuing Company and also the Offered Company needs to comply with the provisions of the Companies Act, 1956 and obtain necessary approvals of its Board of Directors and shareholders, if applicable. (2) The Company intending to offer shares of the offered company under Foreign Currency Exchangeable Bond also needs to comply with all the applicable provisions of the Securities and Exchange Board of India Act, Rules, Regulations or Guidelines with respect to disclosures of their shareholding in the Offered Company. (3) The Company cannot transfer, mortgage or offer as collateral or trade in the offered shares under Foreign Currency Exchangeable Bond and also the Issuing Company is required to keep the offered shares free from all encumbrances from the date of its issuance, till the date of exchange or redemption. Operational Procedure 6|Page

T.Y.B.M.S. - B International Finance N.M.College Semester 6 (1) Prior approval of the Reserve Bank of India is required for issuance of Foreign Currency Exchangeable Bond. (2) The Foreign Currency Exchangeable Bond may be denominated in any freely convertible foreign currency.

Pricing The rate of interest payable on Foreign Currency Exchangeable Bond and the issue expenses incurred in foreign currency is within the all in cost ceiling as specified by Reserve Bank of India under the External Commercial Borrowings policy. At the time of issuance of Foreign Currency Exchangeable Bond the exchange price of the offered listed equity shares will not be less than the higher of the following two :(i) the average of the weekly high and low of the closing prices of the shares of the offered company quoted on the stock exchange during the six months preceding the relevant date; and (ii) the average of the weekly high and low of the closing prices of the shares of the offered company quoted on a stock exchange during the two week preceding the relevant date.

Maturity The minimum maturity of the Foreign Currency Exchangeable Bond shall be five years for purposes of redemption. The exchange option can be exercised at any time before redemption. While exercising the exchange option, the holder of the Foreign Currency Exchangeable Bond will take delivery of the offered shares. Cash (Net) settlement of Foreign Currency Exchangeable Bonds is not be permissible. Taxation on Exchangeable Bonds 7|Page

T.Y.B.M.S. - B International Finance N.M.College Semester 6 (1) Interest payments on the bonds, until the exchange option is exercised, are subject to deduction of tax at source as per the provisions of Income Tax Act, 1961. (2) Tax on dividend on the exchanged portion of the bond according to provisions under, Income Tax Act, 1961. (3) Exchange of Foreign Currency Exchangeable Bonds into shares or Transfers of Foreign Currency Exchangeable Bonds made outside India by an investor who is a person resident outside India to another similar investor, will not give rise to any capital gains liable to income-tax in India. End-use of proceeds requirements The proceeds of Foreign Currency Exchangeable Bond may be invested by the issuing company in: The promoter group companies receiving investments out of the FCEB proceeds may utilise the amount in accordance with end-uses prescribed under the External Commercial Borrowings policy.

The promoter group company receiving such investments will not be permitted to utilize the proceeds for investments in the capital market or in real estate in India. Overseas by way of direct investment, including in Joint Ventures or Wholly Owned Subsidiaries subject to the existing guidelines on Indian Direct Investment in them. Analyzing Foreign Currency Exchangeable Bonds (FCEBs) Initially when it came to borrowings in foreign currency, Indian companies hitherto had two options, namely: (i) External commercial borrowings (ECBs) where they borrow monies in foreign currency, or (ii) Foreign currency convertible bonds (FCCBs) where they issue bonds denominated in foreign currency that are convertible into shares of the issuer company. On 15th Feb 2008, the Ministry of Finance granted Indian industry a third option, which is Foreign Currency Exchangeable Bonds (FCEBs). Under this option, an issuer company may issue FCEBs in foreign currency, and 8|Page

T.Y.B.M.S. - B International Finance N.M.College Semester 6 these FCEBs are convertible into shares of another company (offered company) that forms part of the same promoter group as the issuer company. Simply put, if company A issues FCEBs, then the FCEBs will be convertible into shares of company B that are held by company A and where companies A and B form part of the same promoter group. Fundamental differences between an FCCB and an FCEB FCCB offering FCEB offering 1. Conversion of shares The bonds convert into shares of The bonds are convertible into the company that issued the shares not of the issuer company, bonds but that of another company forming part of its group. 2. Issuance of fresh shares On conversion the issuer company When conversion option is issues fresh shares to the holder in exercised, there is no issuance of exchange for the bonds fresh shares. There is a transfer by the issuer company of the shares it holds in the listed (offered) company to the holder in exchange for the bonds.

Advantages of the scheme: 1. New Avenues for investment - It provides additional avenues for Indian companies raising funds from overseas. 2. Helps companies unlock the value of their holdings in other companies Simply stated, it allows companies (such as holding companies or investment companies) that hold shares in other group companies (which are listed on the stock exchange) to leverage on the value of their investments by borrowing on their strength. 3. Assists companies raise financing without further dilution - For instance, instead of a listed company issuing further shares to raise capital, one of its promoter entities may issue FCEBs on the strength of its holding in the listed company and fund the listed company with the proceeds of the FCEB offering. This way, the promoter entitys shareholding in the listed company would not be diluted at all, unlike in the case of direct capital raising by the listed company. 4. Seemingly, no perceived disadvantages from a taxation standpoint 9|Page

T.Y.B.M.S. - B N.M.College

International Finance Semester 6

Disadvantages of FCEB route: 1. Limited scope - It is permissible only in certain areas and to the extent that ECBs and FCCBs are permitted. 2. Bankruptcy proof - Although the FCEBs are issued on the strength of the underlying shares held by the issuer company, it does not automatically means that the shares are pledged in favour of the FCEB holder. In the event of bankruptcy of the issuer company prior to conversion, the position of the FCEB holder would be only that of an unsecured creditor, and to that extent, this structure is not bankruptcy proof so far as the issuer company is concerned. 3. End-use of proceeds of FCEBs cannot be used for investment in the real estate sector or in capital markets. 4. Policy change - Changes effected to the ECB/FCCB policy last year have restricted such borrowings only to very limited types of activities. This has resulted virtually in a demise of these routes, unless and until they are resuscitated by further policy change. Therefore, unless foreign currency borrowings are permissible for Indian companies in a wider array of activities and with lesser restrictions, it is unlikely that the route will be utilized meaningfully by Indian companies. Until then, it will remain on the rule book without implementation, since the disadvantages pretty much overshadow all its benefits that are largely on paper. However, any positive changes to the policy on foreign currency borrowing will spring this route into action.

Bibliography
Websites Wikipedia www.en.wikipedia.org/wiki/Non-deliverable_forward Ministry of Finance, India http://finmin.nic.in/the_ministry/dept_eco_affairs/capital_market_div/Exchangeabl eBonds.pdf. Reserve Bank of India http://www.rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=9765 http://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=4493 http://www.rbidocs.rbi.org.in/rdocs/Publications/PDFs/80592.pdf Indian Corporate Law 10 | P a g e

T.Y.B.M.S. - B International Finance N.M.College Semester 6 http://indiacorplaw.blogspot.com/2008/02/analysing-foreign-currencyexchangeable.html

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