Broad Principles for Undertaking Derivative Transactions
The major requirements for undertaking any derivative transaction include:
In addition to generic derivative products, market-makers may also offer structured derivative products to users as long as they do not contain any derivative instrument as underlying and have been specifically permitted by RBI in its Master Direction No. 1/2016-17 dated July 5, 2016 on ‘Risk Management and Inter-Bank Dealings’ and guidelines contained in RBI’s Circular DBOD.No. BP.BC.86/21.04.157/2006-07 dated 20 April 2007 on Comprehensive Guidelines on Derivatives and further amendments issued vide circulars DBOD.No.BP.BC. 27 / 21.04.157/2011-12 dated 2 August 2011 and DBOD.BP.BC.44/21.04.157/2011-12 dated 2 November 2011 (‘the Comprehensive Guidelines on derivatives’)
a. The following derivative instruments used to hedge an existing interest rate and forex exposure, on a standalone basis, may be treated as generic derivative products:
o Forex Forward Contracts
o Forward Rate Agreements
o Interest rate caps and floors (plain vanilla only)
o Plain Vanilla Options (call option and put option)
o Interest Rate Swaps
o Currency Swaps including Cross-Currency Swaps
o Exchange traded Currency Futures
o Exchange traded currency options
b. The following derivative products may be treated as structured derivative products:
o Instruments which are combination of either cash instrument and one or more generic derivative products
o Instruments which are combination of two or more generic derivative products
Market-makers should be in a position to arrive at the fair value of all derivative instruments, including structured products on the basis of the approach specified in the Comprehensive Guidelines on derivatives.
It may be ensured that structured products do not contain any derivative, which is not allowed on a standalone basis. Further,
All permitted derivative transactions, including roll over, restructuring and novation can be contracted only at prevailing market rates.
All risks arising from derivatives exposures should be analysed and documented, both at transaction level and portfolio level.
The management of derivatives activities should be an integral part of the overall risk management policy and mechanism. It is desirable that the board of directors and senior management understand the risks inherent in the derivatives activities being undertaken.
Market-makers should have a ‘Suitability and Appropriateness Policy’ vis-à- vis users in respect of the products offered, on the lines indicated in the guidelines given in the Circular.
Market-makers may, where they consider necessary, maintain cash margin/liquid collateral in respect of derivative transactions undertaken by users on mark-to-market basis.