Don’t be damned by the dollar

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Graph 1 shows the fluctuations of the rupee-dollar exchange rate. Over the last year, RBI appears to have been permitting a market determined exchange rate to a greater extent, as opposed to the efforts that used to take place earlier to prevent the market from determining the exchange rate.

A lot of households and firms are thus presented with currency risk, or the losses that they could suffer if adverse currency movements took place. Some people could lose if the rupee depreciates (for example importers) while others could lose if the rupee appreciates (for example exporters). All of them require a healthy currency derivatives market on which hedging, speculation and arbitrage involving a variety of exchange rates can be done.

In the aftermath of the Percy Mistry and Raghuram Rajan reports, exchange-traded currency derivatives’ trading has begun in India. This is one of the most important milestones in India’s financial system development. At present, the biggest financial product in India is derivatives on the Nifty index. These are futures and options that are cash-settled based on the official value of Nifty. In identical fashion, futures on the rupee-dollar rate are cash-settled to the official rupee-dollar exchange rate. One contract on this market pertains to $1,000. As an example, an order for 1,000 contracts of the INR/USD futures is an order for $1 million.

The key advantage of the currency futures market is transparency and competition. The NSE screen is fully transparent (http://tinyurl.com/53gc7q). There can be no cheating on the price. And, all NSE members offer the service of taking orders; their competition drives down the intermediation charges. NSE’s clearing corporation absorbs the credit risk of this market: if any one securities firm goes bankrupt, the clearing corporation ensures that no counterparty is affected. These design features make the currency futures market a safe place to transact.

In this time of unprecedented uncertainty about the currency, trading volume has risen rapidly after the permission was given. Graph 2 shows the time-series of trading volume on the dollar-rupee futures at NSE. In the early days, it was at roughly Rs 200 crore a day. This has gone up to roughly Rs 600 crore a day over a period of around 1.5 months. If the key policy constraints are removed, there is a good chance that currency derivatives would be bigger than equity derivatives.