Hundreds must have gasped when the bell-string snapped at the hands of the Finance Minister during the launch of the currency futures trading at NSE on August 29. The fears, however, were misplaced. With the open interest exceeding USD 50 million within days of its launch, the currency futures market appears to be on sound footing. It goes to show that potent omens, even in this country, are powerless before an idea whose time has come. Indeed, the introduction of exchange-traded currency futures in India has been long overdue. By 2007 the foreign exchange market in India has grown into the 16th largest in the world with total daily turnover of US$34 billion and reached USD 48 billion during 2007-08. Trading volumes in the Indian rupee have risen close to four times between 2004 and 2007 and the Indian rupee?s share of world currency transactions has more than doubled from about 1.5% of total currency transactions in the world in 2004 to about 3.5% in 2007. Most of India?s top companies depend heavily on foreign exchange earnings. Turnover in the OTC derivatives segment of the foreign exchange market – forward and swap contracts – had also catapulted to a daily average of USD 24 billion, 17th largest in the world, in 2007. Customised hedges however have their problems. Sophisticated derivatives-based currency hedges sold to companies by banks have led to several court cases when the bet went awry with the companies claiming they were misled by the banks. The need for a transparent, easy to understand instrument to hedge currency risk was never more acute than in India in recent years.
Even then, the first exchange traded Indian rupee based futures came into existence not in India, but in Dubai. Its success demonstrated the necessity of the product and perhaps finally spurred policy-makers in India to have our own currency futures. As Ajay Shah has pointed out in an earlier column, the futures launch suffers from a few shortcomings including the barring of NRIs and FIIs from the market. A large part of foreign currency transactions in India is driven by foreign investors? discovery of India. There has been a gush of foreign investment flows into the country till late 2007. Between 2002 and 2007 foreign investment inflows had grown at a compounded annual growth rate (CAGR) of over 26%. The sources of these funds have been myriad. Foreign Institutional Investors seeking pure portfolio investments, private equity firms picking up large blocks of shares and all-out foreign direct investment have all contributed to the surge of capital inflows, aided by external commercial borrowings (ECBs) by Indian companies. Foreign players in India are likely to constitute an important constituent of the hedging demand for currency futures. One can understand the fear of off-shore speculators destabilising the rupee, but given the low (5 million USD) position limits, this seems like being somewhat paranoid and there is no particular reason to believe that destabilising speculators are likely to be exclusively or even predominantly foreigners.
Given this exclusion of foreigners, the currency futures in India, together with those trading in Dubai, create an interesting situation where the resident and the non-resident markets for the Indian Rupee-USD futures are now neatly segregated. If there is any sizeable difference in the future prices in the two markets, it is only a matter of time before arbitrageurs figure out a way to profit from it. Problems notwithstanding, a few key features of the NSE currency futures deserve praise. First, the contract size. At USD 1000 it is a fraction of the Dubai contract size of 2 million rupees. This makes it much more amenable for small businesses to use them as a hedging device, ameliorating the indivisibility disadvantage of futures vis-?-vis forward contracts. Also with twelve monthly contracts alive at any point in time, the horizon matching problem for a hedger is reduced as well. Once again this is an improvement upon the Dubai product which provides quarterly maturities beyond the first quarter. As of now, the action is restricted, perhaps unsurprisingly, to the immediate run of one quarter with some action at the longest end, but as time passes, all horizons should witness greater activity.
The currency futures market constitutes one of three major derivative segments, with the other two being interest rates and credit risk. Interest rate derivatives are scheduled to make a second attempt at launch very soon. Done right, they are likely to swamp the currency futures markets. Worldwide, at the end of second quarter of 2008, the amount outstanding for exchange-traded interest rate futures stood at a staggering 153 times that for currency futures with a turnover that was 58 times higher! There are reasons to believe then that this is just the beginning – the beginning of a whole new era for Indian financial markets.
The author teaches finance at the Indian School of Business, Hyderabad.