Sustainable Currency Derivative Framework for Effective Risk Management of Indian Corporates

Abstract

In the first decade of the current century, the liberalized economy of India witnessed a manifold increase in global trade, owing to which Indian corporates were exposed to the foreign currency fluctuation thus risk of loss due to currency fluctuation. Although forward contracts are the most prevalent derivative contracts to hedge currency risk. However, Indian corporates have undertaken other forms of derivatives such as swap, option, and swap options to hedge foreign currency risk. However, a lack of inherent understanding of the risk on these derivative instruments, which was meant for hedging currency risks, lead several corporates to incur huge losses, forcing them to near bankruptcy. The decade 2005-2010 and thereafter saw large losses owing to derivatives both in India and across many other economies, thus impacting corporate profitability, leading to bankruptcy or near bankruptcy for some Indian firms and firms across the
globe. The losses incurred by corporates led to acrimonious viewpoints between market intermediaries such as banks and Indian corporates on aspects such as the need to undertake such derivatives, leading to litigation, some of which are still pending in Indian courts. Thus, the financial system suffered, and continues to suffer, from many structural gaps and lacks a clear understanding of the products, indicating the need for a robust risk management framework. It is still felt that corporates are yet to define their proper risk appetite and risk management framework to undertake derivatives, particularly currency derivatives. Hence, this study is focused on evolving a suitable framework in developing a currency derivative framework for effective risk management for Indian corporates.