The change in forward premiums is caused by the movement of interest rates in the two currencies. In India, the forward premium market is not perfect as there is no capital account convertibility
Forward premiums are the interest rate differentials between two currencies. For example, the one year GoI bond yield is 3.92 per cent. At the same time, the US one year treasury yield is 0.05 per cent. Therefore, the difference between the two is 3.87 per cent and the one year forward premium for USD-INR (dollar-rupee) should be maintained at this level, ideally to create a conducive market condition.
Quoted in paise, forward premiums are added to the spot rate of the pair to give the forward rate of the currency pair — for example, if USD-INR is at 72.92 and the forward premium for one year is 320 paise, then the forward rate for one year will be 76.12. This 320 paise, when quoted in terms of annualised premium, is 4.20 per cent, contributing to an imperfect market and an arbitrage opportunity.
The change in forward premiums is caused by the movement of interest rates in the two currencies. Any rise/fall in interest rates in the US or India changes interest rates, and the forward premiums adjust accordingly. In India, the forward premium market is not perfect as we do not have capital account convertibility. While the RBI keeps accumulating dollars and pays the premium in the forward market, it also receives a forward premium when it sells dollars in the forward market.
This intervention causes arbitrage opportunities in the market. Higher rates of interest in India also attract traders to receive the differential interest rate between the two countries (the US and India, borrowing in dollar and deploying the rupees generated in Indian debt/equity market). Thus, there is always volatility in the forward premiums. In 2008-09, the forward premiums turned into a discount as the RBI bought all the dollars that were coming as inflows. This created a shortage of dollars and converted the entire forward curve into a discount.
However, the forward premium does not always represent a perfect interest rate differential in our country’s case. The nationalised banks had been receiving premium till March, but the forward premia are usually high at the end of the financial year due to shifting to the new year. The RBI had been buying dollars and started paying heavily in the forward market.
In the first and second week, the spot rose to 75.32 and as the RBI bought dollars and paid forward premia, the near term premium rose. Cash levels went to absurd levels of 28-30 per cent, while the first month premia rose to 8 per cent. The year premium was nearly at 6 per cent. SBI and Canara Bank, the typical receivers of cash premiums, were not receiving the daily premia.
Thus, everybody was a payer, and with no receivers, the premiums remained at elevated levels for about two weeks. Post this, the nationalised banks stepped in on behalf of the RBI and started receiving the premiums and brought it down to normal levels of 5-5.25 per cent for the entire curve. In the past few days, the RBI has been receiving the premiums which has brought down the rate to 3.50 per cent and the one-year premium has been brought down to 4.30 per cent.
The RBI has huge paid positions in the forwards (about $75-80 billion), presumably brought down by receiving in the forward market. We shall come to know about this only in July when the RBI reveals its buy and sell data for the month of May.
A lower-cost will ensure that corporates hedge their payables beyond the near term, say, for more than one month. It will also ensure that the RBI can buy its forwards at a lower rate. On the other hand, increased hedging costs do not induce corporates to hedge their import liabilities except those in the near term despite the spot coming down.
The volatility in forward premia will continue as the RBI keeps paying when it buys dollars and receiving when it sells them. Higher premia will attract carry traders, while low premia will attract importers, with the spot being lower around 72.80 to 73. The exporters should receive higher premia while the importers should pay the current premia at 4.30 per cent for one year.
The RBI will not allow spot to move higher as it will cause imported inflation with oil prices already ruling above $71 a barrel. The range for spot is expected to be between 72 and 74 and the forward premia from 4 per cent to 6 per cent on the one year curve for the month of June. However, the Fed meeting scheduled for June 16 could increase the demand for tapering to start with, causing volatility in spot and premia. This is the most significant risk in recent times.
The RBI will ensure orderly behaviour of the market and will be present from both sides (buying and selling). Importers and exporters should cash in on both the opportunities (by paying at lower levels and receiving at higher levels, respectively) when it comes.
The writer is Head of Treasury, Finrex Treasury Advisors