Currency derivatives and rupee risk

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: Trading volumes in the Indian rupee have risen close to four times between 2004 and 2007, and its share of world currency transactions has more than doubled from about 1.5% to 3.5% during the period. Much of this is driven by foreign investors’ discovery of India. In the last five years, foreign investment inflows have grown at a compounded annual growth rate (CAGR) exceeding 26%. Simultaneously, Indian corporates have gone for external commercial borrowings in a big way. During 2006-07, foreign borrowings of the largest Indian companies amounted to about 30% of their domestic borrowings. Crossborder M&A activity and private equity flows to India have also zoomed.

All these crossborder investment flows, together with enhanced trade flows, create a corresponding need for hedging currency risk, particularly given that the exchange rate is more than twice as volatile in 2007 as it has been in the last few years. That’s where currency derivatives come in. Forwards, options, futures and swaps all help players better manage foreign currency risk.

Demand for currency hedging instruments for the Indian rupee is perhaps best reflected in the relative turnover volumes of forward contracts involving the currency. Forwards are the simplest of forex derivatives that involve an agreement on the price of a future purchase or sale. According to the Bank for International Settlements’ triennial survey, the average forward market turnover in the rupee gently rose from 27% of that of the spot market turnover in 2001, to 31% in 2004. In 2007, the figure more than doubled to 65%.

Currency derivatives available in India today include forwards, options and swaps involving the rupee. All of these are over the counter (OTC) instruments that need to be purchased from banks, as opposed to being exchange-traded. Moreover, several stipulations apply to them. In an effort to ensure that forwards are used only for hedging purposes, resident individuals/firms and FIIs are required to provide proof of their underlying positions before they take positions in the forward market, though moves are now afoot to make things simpler for resident individuals and SMEs. This restricts the market entry of several entities with bonafide hedging needs, not to speak of speculative currency traders.